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It’s not about formalization

Jann Lay | 28 October 2014

The graduation of micro and small enterprises into larger firms is one of the key questions of economic development in many of today’s poor countries. What matters, however, is that these firms generate employment and increase productivity, not whether they are legally formal or not.

Whether labour markets in many of today’s poorer developing countries will be able to absorb the considerable expansion of labour supply in the next two decades crucially depends on the capacity of micro and small enterprises (MSEs) to generate more employment. In addition, income growth and poverty reduction will hinge on improving the productivity of jobs in these firms. An obvious route is by growing existing micro and small firms, which tend to be less productive than larger firms and whose expansion would also fill the missing middle that is apparent in firm size distributions in many poor countries. In these countries, we typically find many micro and some large-sized firms, but too few small and medium sized firms.  

The graduation of microenterprises into small, medium and, eventually, large firms, however, is fairly poorly understood. In fact, there is somewhat inconclusive evidence on the extent to which MSEs in developing countries graduate at all into medium and large firms. Quite a number of studies suggest that the majority of MSEs do not expand beyond a few employees over their lifetime, although some experience substantial growth. Leo Sleuwagen and Micheline Goedhuys (2002) compare firm size distribution in Germany with that of Côte d’Ivoire, and show that 28% of German firms that are medium or large today started as micro enterprises (1–4 employees) and 32% as small firms (5–49 employees), while in Côte d’Ivoire only a negligible fraction of medium-sized and larger firms started much smaller. More recent data for Uganda indicate that 6% of today’s medium and large enterprises were micro firms when they started, and 35% were small firms (author’s computation from the Ugandan World Bank Enterprise Survey 2006), suggesting that the graduation from MSEs to larger firms also happens in the developing world. Indeed, much of the evidence on the dynamic behaviour of MSEs suggests that a significant number of those firms behave very much like a ‘normal’ businesses but operate under various constraints, in particular credit constraints and a risky business environment (for a recent overview see Grimm, Lange and Lay, 2012). This fits well with recent evidence of high marginal returns to capital for certain sub-groups of MSEs (see Grimm, Knorringa and Lay, 2012).

These considerations raise the question whether the graduation of firms and harnessing the potential of MSEs cannot be accelerated by easing formalization, i.e. typically legalizing the status of the firm and corresponding registration with government and tax authorities. A very informative review of evaluations of ‘formalization programs’ by Bruhns and McKenzie (2013) suggests that these efforts have (if at all) only modest effects on the number of formal firms. This is because firms appear to benefit little from formalizing, which in turns explains the former result. The supposed gains of formalizing - for example legalized access to infrastructure, legal processes, or access to social security systems - are not perceived to outweigh the costs of registration and possible tax and social security contribution payments. The specific reasons for the lack of perceived gains are likely to differ across countries. Yet, registration costs appear to be less important than one might think (see some examples from Mexico, Peru, Sri Lanka and Bangladesh provided by Bruhns and McKenzie, 2013) Not surprisingly, the review by Bruhns and McKenzie shows that more efforts in enforcing formalization can be effective and can have positive effects on tax revenue. Yet, it is not clear whether this fiscal benefit provides a sufficient rationale for formalization programs. The findings of this review are quite in line with earlier evidence from Latin America  (see Perry, 2007) that has stressed that entrepreneurs deliberately ‘exit’ formal institutions to avoid, for example, being obliged to contribute to social security schemes that are not delivering adequate services.

This is not to say that easing procedures to formalize may not help firms to grow. If contract enforcement mechanisms are weak for both formal and informal firms, formalization alone is of little help. This implies that formalization policies are useful only if the benefits of being formal outweigh the costs. In turn, these benefits are higher if formalization indeed facilitates access to productive infrastructure as well as functioning administration and contract enforcement mechanisms.

As is often the case in questions about economic development, many things have to change simultaneously to achieve significant progress, which raises the issue of optimal sequencing of policy measures. The above considerations clearly indicate that improving the business environment should come first. This includes reliable access to public infrastructure and contract enforcement mechanisms. Yet, formalizing businesses may also create more demand for a functioning legal system. The same holds for tax revenue: Entrepreneurs who pay taxes may also pay more attention to how these taxes are spent. Taken together, a careful balanced approach towards formalization is advisable. Such an approach should not impose additional costs and focus on bringing real benefits to businesses. 

References

Grimm, M., P. Knorringa and J. Lay (2012). Constrained Gazelles: High Potentials in West Africa’s Informal Economy. World Development, 40 (7), 1352-1368.
Grimm, M., Lange, S., and J. Lay (2012). Credit-constrained in risky activities? The determinants of the capital stocks of micro and small firms in Western Africa GIGA Working Paper, No. 185.
Sleuwaegen, L., and Goedhuys, M. (2002). Growth of firms in developing countries, evidence from Côte d’Ivoire. Journal of Development Economics 68, 117–135.
Bruhn, M. and McKenzie, D. (2013). Entry Regulation and Formalization of Microenterprises in Developing Countries, World Bank Policy Research Paper 6507, Washington D.C..
Perry, G. (Ed.). (2007). Informality: Exit and exclusion. World Bank Publications.

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Jann Lay

Jann Lay is an economist and heads the research programme on development and globalization at the...

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