How do enterprises become 'formal'?
A small brewer in Sierra Leone finds the only way he can compete with cheaper imported beers is by evading sales tax. He'd like to go legitimate but calculates that it would put him of business. Meanwhile, in Brazil, an auto-parts manufacturer would like to get a bank loan to expand but finds that doing so requires an external audit. Because the company has been hiding half its workers from the social security authorities for the last five years, this presents a problem.
Many of us live in a world of regular paychecks, paid holidays, fixed working hours and – unfortunately – annual income tax returns. This has its drawbacks, but it also gives us a sense of security and order without which it would be difficult to plan our lives. It also gives us a feeling of legitimacy and inclusion, albeit at a price, and means we have access to public education, social security, medical care and other services.
Things weren't always this way. Even now, developed countries have large pockets of 'informality' – think of migrant workers in the United States. And informality is even more prevalent in developing countries. Our best estimates suggest that over 30 percent of output and 70 percent of workers in developing countries are to some degree outside the scope of government regulation. Most people also agree the proportion is rising over time.
If there's anything the last two centuries of economy history have taught us, it's that states are indispensable for making markets and public services work on a large scale. But this doesn't mean that all viable states will look the way they do in Europe and the United States. We need to uncover ways of making existing institutions in developing countries perform the same functions they do in developed countries.
How does this process occur in practice? Is changing laws and regulations enough, or are we talking about something more fundamental? How can policy-makers contribute? Please add your comments below and join the debate...
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"If there's anything the last two centuries of economy history have taught us, it's that states are indispensable for making markets and public services work on a large scale."
Tom, I think we have to be more specific than this. I never met anyone who, for the basics of life, did not prefer stability, regularity and order to risk, uncertainty and chaos. But, at our moment of history, it is not clear where the rules should be located that guarantee participation in orderly markets.
The alternatives are world society, regional federations like the EU and NAFTA, transnational associations, nation-states, local groups and networks of all sorts. In reality we all rely on a combination of most of these. 'The state' is only the answer if it includes all of them.
In the last few years, I have been approached on three separate occasions to take part in international standardization exercises. One, initiated by the ILO, concerned labor law in the face of widespread informality. Here one consideration was that transnational corporations cannot be expected to adapt to rules that are different for every country they invest in. The second was brought up by the International Federation of Organic Agriculture Movements (IFOAM) and it concerned norms for international trade in organic products. Third, a Brazilian NGO proposed a sort of Standard and Poor's index for rural municipalities worldwide which would regularize the standards required by multilateral agencies for funding their development, while acting as a measure of what these local areas might be expected to achieve.
It is still the case that nation-states will normally enforce the rules of economic life. But they are less than ever the source of these rules. Your own institution, the World Bank, plays a major role in negotiating this transition from the state to world society as the framework for 'formality'.
This situation may have been in place, to some degree, for two centuries, but it takes on a particular urgency at this time.
Posted by: Keith Hart | Nov 7, 2006 8:17:08 AM
Keith,
You're right that some of the rule-setting that occurs nowadays goes on at the supranational level. But, as you acknowledge, they're generally enforced locally. And compliance (or participation, depending on your point of view) is the larger part of the problem. Take your norms for trade in organic products. I'd like to know more about how information about these norms is diffused to farmers, how buyers checks that standards are being met etc. My colleagues at the World Bank in Washington DC can't do this - we have to rely on intermediaries, whether local governments or business associations or someone else. And where there are no intermediaries, we're in trouble. What interests me is how we might develop them.
Posted by: Tom Kenyon | Nov 7, 2006 11:19:03 AM
Tom,
"I'd like to know more about how information about these norms is diffused to farmers, how buyers checks that standards are being met etc."
Perhaps this is off the main track you want to pursue here, so I will be brief. IFOAM is the link to farmers and their activists have access to a big book called 'Norms' which is constantly updated. The whole bureaucracy of authentication is expensive, but some farmers think it is worth it if it helps them gain access to US and EU markets, where middle class consumers are prepared to pay a premium for 'organic' food. But 95% of international trade in organic foodstuffs is handled by a half-dozen transnational corporations led by Nestles. They are the main intermediaries.
Keith
Posted by: Keith Hart | Nov 13, 2006 4:01:13 PM
You ask very pertinent questions on 'informality' here; queries that economists oft forget to pose (and checking your resume, I see why you - as political scientist - fail not to ask them).
You state:
"[T]he last two centuries of economy history have taught us...that states are indispensable for making markets and public services work on a large scale...this doesn't mean that all viable states will look the way they do in Europe and the United States. We need to uncover ways of making existing institutions in developing countries perform the same functions they do in developed countries."
You may be right in the assessment that 'states are INDISPENSIBLE for making markets and public services work on a large scale.' However, decades of experience in most developing states shows that the state has more often been predatory than promote public services or unleash entreprenuerial potential of people.
That is one reason why informality persists: making certain aspects of your dealings formal in predatory jurisdictions leads to a sub-optimal outcome.
To change this scheme of things one would - inevitably! - have to engage in reforming or transforming state institutions. This is a highly political act, perhaps somewhat beyond the scope of the Bank, particularly the IFC.
There may also be another reason (for informality): that an informal transaction may - even in situations where the state is effective and non-predatory - be more efficient than a formal one. It is this latter situation that may be interesting to explore under your first query - "How does this process occur in practice?" - and it questions the subtle normative aspect of the following question - "Is changing laws and regulations enough, or are we talking about something more fundamental?" Maybe we are better off not changing laws and regulations, but rather the answer to the third query - "How can policy-makers contribute?" - may be what contribution can be made to better facilitate informal networks and transactions, when one cannot change/reform/state institutions.
What do I mean by all this?
Let me take the example of 'hawala' -an informal way to transfer money in large areas of the developing world (particularly Muslim societies and large portions of South Asia).
Hawala is a financially organic response in societies that have strong family networks and extended social networks, and where states have discouraged the use of foreign capital via high taxation or outright prohibitions.
Consider a Bengali engineer in Silicon Valley, who wants to send money to his parents to ensure long-term care (substitute for: social security and medi-care), provide money to his sister's college education (substitute for: FAFSA, education subsidy and public scholarships) and get a rickshaw driver to take them around (substitute for: public transport). Bangladesh does not quite yet encourage remittances, and even sending them via the formal banking system costs at least 5% (at most around 15% or more) of the total amount being remitted.
Informal networks, like giving a distant cousin who owns a 7-11 in Frisco, or giving the Imam of an SF mosque, $1000 to ensure that the equivalent in Bangladeshi taka (where the exchange rate in the 'black' informal market is quite high) be delivered to his parents. An Imam in a Dhaka mosque or a friend, of the cousin who owns the 7-11, and operates a hawala outfit in Dhaka will deliver nearly 100 percent of the formal exchange rate equivalent of $1000 in Dhaka. A savings of more than $50-$150! And it provides for social security, medicare, education and transport!
You may counter that this is not on SCALE. And one would agree(but what if there are 10,000 software engineers doing the same for families back home, affecting say about 5 people per family: 50000 lives changed; not bad on scale I'd say). But so long as the state remains ineffective, and there is not much scope of effecting change (even institutions such as the IFC, Fund and Bank acknowledge the difficulty of reforming and transforming institutions, especially political ones), then it may be better to increase and facilitate informal transactions! Perhaps ways may be devised to show how the informality of an economy yields growth, reduces poverty, promotes the private sector.
Unfortunately, our aversion to things informal leads to formation of policies that are even counter-productive for development.
Taking the hawala example further: following the events of 9/11/2001, the US government and FATF have tried to formalize the hawala system. Yet, why would the users of this system - who use it for legitimate reasons, like helping their families - sign on to such efforts? We know terrorists use the system, but that does not mean everyone using the system is a terrorist.
Moreover, the formal banking systems in the developing world are now required to meet FATF standards, and replicate 'Know Your Customer' and other provisions that increase their transaction costs, in order to be able to do business and have access to developed world capital markets. How can such banks cope with the new requirements when formal banks in the developed world are finding it hard? The result: informal transactions are encouraged, becaue the formal banking system - which is already fragile in many cases - in the developing world is exposed to more stress, in order to formalize the economy! A policy outcome that typifies perverted irony...Formalization increases informality...
I bring the issue to your attention here to show that: informality may actually be good, and perhaps a pareto-efficient outcome (eg: reduced transaction costs in sending remittances); or it may be a satisficing outcome, in the context of weak state institutions that cannot be reformed by development orgs. like the Bank.
Perhaps this provides no semblance of sense; in that case, my apologies.
Posted by: Chanakya | Nov 15, 2006 5:36:08 PM
Chanyaka,
I found your comments very interesting indeed. (And thank you also for correcting my spelling!) I knew my remark about the indispensibility of states would get me into trouble.
I suspect one's attitude towards ‘formalization’ depends on two things: the degree to which one thinks of markets as self-organizing; and the extent to which one regards state authority as legitimate. Certainly there are instances in which, as you argue, private informal networks function relatively efficiently – your hawala system is an example, and there are many others, even in jurisdictions with well-functioning market institutions. You are also right to point out that informality can be a legitimate response to harassment by government officials. I would be among the first to admit that there are limits to formalization and that understanding how informal entrepreneurs view the pros and cons of compliance with regulation is a necessary first step. But for now I’ll stick to my position that ‘state-building’ is a worthwhile aim, even if we disagree over what these states look like.
First, there many other situations in which entrepreneurs have had trouble solving the coordination, information and other problems associated with making markets work. (Incidentally, Marcel Fafchamps’ book ‘Market Institutions in Sub-Saharan Africa’ neatly documents some of the limits of African markets that rely on social networks or shared ethnicity to deal with transactions costs – among them the high proportion of gains from trade that are appropriated by intermediaries etc.). I doubt that private provision of public goods, as a colleague neatly put it to me yesterday, is really feasible on the sort of scale in which we are interested. Last time he was in Washington, Keith argued that this might happen in Sub-Saharan Africa – spearheaded by South African multinationals interested in developing hydro-electric and mineral resources. It’s also the idea behind the growth poles projects some colleagues of mine are involved with in Madagascar. This may work where existing large companies have an interest – but it’s not a recipe for equitable development, in my opinion.
Second, not all state-society relations are like those in Chechnya or Somalia. True even the United States has its libertarians. But there are many countries, particularly middle income countries, in which parts of the state function fairly well and in which most citizens would accept the idea that it should tax and regulate their, or at least other people’s, activities. Are we really suggesting that we should junk what we already have? Much better surely to extend it gradually, incorporating some informal practices while discouraging others, perhaps through a process of mutual accommodation. And here is the rub – all collective organizations depend on some mix of norms of reciprocity and sanctions, whether they are states, business associations or pretty much anything else. Building this reciprocity is tough – whether we’re talking about tax requirements, or health and safety standards or other restrictions on economic activity that require individuals to make short term concessions.
Where does this leave the WB? You seem to suggest that root and branch reform is the only option. I doubt it. A more promising approach may be to encourage and learn from local adaptation and experimentation. With luck, we may be able to find situations in which authorities and private entrepreneurs have been able to negotiate a solution – as in Ghana, where trade unions collect taxes on behalf of the state; or north-east Brazil where small business associations and local governments have collaborated in enforcing quality standards for agricultural exports. After all, this process of trial and error is pretty much how workable institutions emerged in much of the developed world (and let's remember that my and Keith's own country, England, has been dominated by a ‘predatory’, extractive monarchy for much of the last thousand years.)
The point is that where the potential for a voluntary accommodation between states or other viable organizational forms exists, we should be thinking of and documenting ways of encouraging it.
Tom
Posted by: Tom Kenyon | Nov 16, 2006 12:41:56 PM
I think it's time to move the debate on. We've agreed - more or less - that formalization can be a worthwhile policy goal. But how does it work in practice? What are the obstacles and how can we get around them? Let me give you an example. According to the IFC's survey of informal firms in Sierra Leone, lack of information is the single most important deterrent to acquiring a business license – ahead of costs and inconvenience. In Kenya, the government has enacted myriad policies towards the 'jua kali' since the 1980s, but probably only a fraction of informal sector entrepreneurs know anything about them. In other words, lack of information is a serious problem. What's the solution?
Posted by: Rina Oberai | Dec 5, 2006 5:38:35 PM
In Sierra Leone, the informal sector forms a sizeable proportion of the economy and conditions stimulating the growth of this sector is similar or the same with the conditions in other developing countries. Several socio-economic factors such as inability to access credit from the formal banking sector, inefficient utilization of tax receipts vis-à-vis higher taxes levied, level of education, etc, affect the size of the informal sector.
Due to the complexity of this sector, it relatively poorly understood. No individual factor appears to be responsible for businesses operating within the informal economy. It is therefore unlikely that any one individual measure alone will succeed in reducing its size.
It is true that in Sierra Leone lack of information as stated by IFC is a major problem. I think the following options could help alleviate this problem:
establish ‘one-stop-formalization shop’ within the financial institutions that will assist the dissemination of information, and also provide business support in the areas of:
(i) tax rules and regulations;
(ii) book-keeping;
(iii) marketing strategies;
(iv) registration procedures etc.
Create public awareness campaigns around critical business topics such as the benefits of formalization against the risk and cost of informality through workshops, seminars, radio discussions, etc.
Involvement of Local Councilors in the public awareness campaigns as they are key stakeholders in the districts.
Posted by: Mohamed Salisu | Dec 8, 2006 9:51:24 AM
Mohammed, I think the idea of a "one-stop formalization shop" is great. We've actually started to work on a similar approach at FIAS. It probably needs to be combined with a simplification of registration requirements, and a simplified tax regime for small businesses. A basic question is where to host the shop’s operations. An existing government office can be assigned or a new agency (private or public) created. As with all other one-stop models we need to be aware of the risk of the one-stop approach degenerating into a "one more stop" instead of facilitating formalization.
Another big challenge is to ensure an expansion of services to informal entrepreneurs across the country (usually done via regional one-stop shop antennas), while making sure that there is enough capacity and avoiding giving too much discretionary power.
I also want to follow-up on the discussion raised by Chanakya on the role and indispensability of the state and the risk of doing harm by pursuing formalization when circumstances are not right. At the moment, I'm with a FIAS team in Liberia to launch a survey on the country's economy aiming to identify the key issues and constraints that informal entrepreneurs face when trying to formalize their activities.
Liberia is probably not the first country one has in mind when thinking about enterprise formalization. Governments have been busy fighting civil wars for most of the 90s until Charles Taylor was forced to leave the country in 2003. Basic infrastructure has been largely destroyed. Needless to say that Liberia also lacks the legal environment to provide basic judicial services to its entrepreneurs. After years of disregard for the rule of law, disputes are settled through informal mechanisms and firms certainly can't rely on the government to protect their investments. Establishing a clear formal system of land ownership remains one of the biggest challenges today and while the Liberian government recently engaged in a zero tolerance policy towards corruption, abuse of discretionary power remains a problem for businesses at all levels. Official unemployment rates are above 80% and the informal economy is the largest source of employment and income for Liberians.
So, what's the benefit of formalization for informal entrepreneurs in Liberia? Should formalization be a policy goal for the Liberian administration?
I'm not sure. The most obvious danger for peace are unemployed ex-combatants. In a fragile environment, protecting livelihoods and job creation - formal or informal – come first. So I agree, Chanakya, that in many cases when state institutions are at best ineffective the right question to ask is "What can be done to facilitate informal activities?" instead of pushing for more formal mechanisms that might undermine important livelihoods, and risk handing over informal entrepreneurs to predatory state officials.
Yet, what is striking in the case of Liberia is that there is enormous interest among government officials to facilitate formalization (reform cumbersome procedures, develop a simplified regime for micro and small enterprises, provide training and other services). This eagerness to reform provides a chance to get the fundamentals right. While formalization might not be an early priority, these reforms could play a significant role in speeding up the long term economic recovery of the country. So why not use the opportunity? Reducing the barriers to formalization does not hurt and reforms are likely to become significantly more difficult once interests within various government bodies become vested.
Evidently, the focus needs to be on providing incentives for voluntary formalization and to refrain from enforcement. The simplification of procedures should go hand in hand with the provision of services. Sure, capacities are very limited in Liberia but sometimes small carrots might be sufficient. For small scale miners a reliable claim to their mining parcel might be reason enough to get a mining license and comply with tax requirements. For small coffee growers in Rwanda or Litchi producers in Madagascar, trainings to meet product standards for export markets alone might justify paying registration fees and taxes. When these incentives work, word on the value of a formal status is likely to spread (informally). So, rightly targeted incentives combined with a "one-stop formalization shop" and the elements of public information campaigns highlighted by Mohammed might be part the answer to Rina’s question.
Posted by: Jan Loprick | Dec 14, 2006 5:34:32 PM
In the 'formalization' debate, discussing how to simplify the registration procedure is really important. I like very much the idea of "one-stop shop" , which would bring formality much closer to informal entrepreneurs. However, I think that the raise of informality -which is occurring in most developing economies- requires us to understand a wider variety of aspects, that go beyond the cost\benefit analysis that entrepreneurs make when they choose between formality and informality.
One first point, is that most literature refers to formalization as a means for micro-enterprises to pursue economic growth. Formal firms, in fact, can have access to credit, support of public institutions, more secure property rights etc. In my view, this is an issue where we should change perspective. Most informal operators, in fact, are self-employed or family businesses. In these types of activity, grand part of the choices made by the entrepreneurs are not based on the idea of 'profit maximization'; entrepreneurs would prefer to support the livelihood of a family member, although this is not efficient in terms of profits. In my view, this fact leads to the idea that formalization in most circumstances should be proposed as a way to reduce the level of vulnerability of enterprises, rather than being offered as a way to became successful entrepreneurs.
The second issue, refers to the fact that the 'formalization approach to development' should re-define the meaning of formality itself. My impression is that this definition is entirely based on western standards, on western economic institutions. It is necessary to realize the difficulty (or impossibility) to regulate parts of the economies which have never been formalized -at least in its contemporary meaning. The major objective, therefore, is to understand what are the non-formal institutions that micro-entrepreneurs would be forced to change once they decide to follow the rule of law. In my view, beside the costs of the formalization procedure, the major obstacle is how entrepreneurs perceive the change of life-style that usually follows the regularization of the firm. This is not an attempt to 'romanticize' about the informal sector, it is just a way to realize that it is very unlikely to find a 'best-practise' outside the realm of the 'moral economy' which is often how informal operators secure their livelihoods. I admit it is hard for a bureaucracy to regulate such informal practises and institutions. But it is for this reason that I would suggest that the focus of formalization should not be reduced to simplifying the procedures (as for example, with one-stop shops). What is really needed is a representative body of informal operators capable to negotiate with governments the ways in which formalization will occur, considering especially the countless amount of informal institutions that are not going to disappear with formalization procedures.
Posted by: Edoardo Totolo | Dec 18, 2006 5:52:22 AM