Registration Rules

FIGURE 1.2 Formal and Informal Sectors with Entry Costs and Size-Based Registration Rules

Source: Original figure produced for this publication. Note: Q is the official threshold for registration. P is the level at which the net gains from formalizing become positive, and r the level at which they are sufficient to cover the entry cost.

Firms with a natural size greater than R (type A) will register. Firms with a natural size between Q and R will not want to register because the net benefits they accrue from formalization will not cover the entry costs. They will either avoid or evade the regulation. Specifically, firms that have a natural size significantly above Q but below R (type B) will find that remaining at their natural size, while evading the labor regulation by not registering, is optimal. Firms with a natural size slightly above Q (type C) will find that avoiding the regulation by remaining slightly below the size threshold Q is optimal. These firms will choose not to reach their full natural size and thereby remain legally outside the regulatory net.

As before, firms with a natural size below Q do not need to alter their behavior because of the size-dependent registration requirement. These type D firms—the outsiders—are arguably informal because of their small natural size and not because the owners wish to avoid or evade regulations. Given their current productivity levels, changing the cost of labor regulations or the intensity with which those regulations are enforced is unlikely to alter their decision to remain informal. This is especially true of firms with natural size below P, which have negative gains from formalization even after excluding entry costs.

Evasion and avoidance behaviors add to the distortions in the economy. Avoiders remain inefficiently small. This distortion in firm size because of size-dependent regulation and its toll on aggregate productivity is a major concern of economists. It is likely

that evaders resort to suboptimal practices to hide their noncompliance, such as hiring workers informally to keep them off their rolls, impeding the performance of the firms and the workers.

POLICY LEVERS INFLUENCING INFORMALITY

The conventional policy levers for reducing informality involve reforms to business licensing requirements and product and factor market regulations that begin to apply at the threshold of the formal sector. Their impact depends on the extent to which the informal sector consists of evader and avoider firms. They have little direct impact on outsider firms.

For example, suppose there is a fall in the cost of compliance with labor regulations that start binding at size Q. This will shift the curve representing the net gains from formalizing upward at points Q and above, thereby inducing some type B and type C firms to formalize. Type D firms, however, will be largely untouched because the change in the regulatory cost will not affect their natural size or their gains from formalization.

Another option is to increase the intensity of regulatory enforcement among likely evaders. In terms of the framework, this would increase the expected penalty for evaders. Some evaders will start complying with the regulations, while others may choose to avoid the regulations altogether by shrinking to the point where they are legally outside the enforcement net, that is, by turning into avoiders. The total level of informality and the distortions caused by regulatory evasion will decrease, but the distortion caused by firms choosing to stay below their natural size to avoid the regulatory threshold may increase.

The price for achieving meaningful reductions in regulatory compliance costs and strengthening enforcement has to be weighed, too, in considering such policies. In lowering the costs of complying with regulations, not compromising the achievement of the intended impact of the regulations is important. Doing this may involve sizable investment in regulatory redesign and capacity-building measures, such as staff training and information technology system upgrades. Increasing enforcement intensity may likewise require expensive investments in enforcement capacity.

In addition to regulations, other levers are available to policy makers that do not target informality directly, but may still improve conditions in the informal sector and raise the productivity of the economy. Their impact is not restricted to those informal firms that are evading or avoiding regulations.

Reforms that reduce distortions in the formal sector may affect the informal sector indirectly. The impacts depend on the nature of product market links between the two sectors. If informal firms produce goods that are substitutes for those produced by formal firms, this will decrease the demand for informally produced goods, causing