Likely Effect of Reforms on the Informal Sector: Productivity Impacts

Regulatory and tax policy reforms are important because of their potential economywide productivity impact; however, as shown in chapters 2–4, they have limited potential to transform the informal sector directly. One reason is that a large group of firms will not benefit directly from these reforms because they are far from the size thresholds that trigger compliance. This may explain why business licensing reforms have had limited effect on the informal sector. Nevertheless, the wider productivity impacts of such reforms may have sizable spillovers on informality in the long run. As is explained in chapter 2, the total potential for such long-run indirect impacts may be large given the sheer extent of the distortions in resource allocation that still characterize South Asian economies.

Identifying specific reforms with the potential for a large impact on aggregate productivity, however, remains a challenging policy research agenda. One such reform is the implementation of the VAT system. As is estimated in chapter 3, this reform had sizable economy-wide productivity effects, including indirect effects on the informal sector, but limited direct impacts on informal firms. It thus remains important to find ways to address directly the demand- and supply-side constraints to the growth of informal firms, particularly outsider firms.

BUSINESS ENTRY REFORMS HAVE LIMITED EFFECT

The exclusion view of informality emphasizes the potential of reforms that lower entry barriers to the formal sector to help informal firms formalize and grow. As described in the framework, this impact depends on the number of informal firms poised at the threshold of formality.

Perhaps motivated by the exclusion view, the simplification of business entry procedures has recently been among the most common types of regulatory reforms enacted by low- and middle-income countries, including South Asian ones. For example, in 2004–11, governments and stakeholders in 54 countries introduced new technology to simplify company registration processes (Wille et al. 2011). In 2004, 124 countries required entrepreneurs to deposit a fixed minimum paid-in capital amount legally with banks or notaries before incorporating a business. By 2019, more than half of these countries had eliminated this requirement (World Bank 2020b).

The evidence on the impact of such reforms on informality is sobering (Bruhn and McKenzie 2014; Jayachandran 2020). Several studies find that efforts to ease the registration process among firms can lead to a modest increase in registration rates, but not all do. For example, in a randomized controlled trial in Bangladesh, the delivery of information to informal firms on registration procedures had no significant impact on formalization (De Georgi and Rahman 2013). Similarly, when randomly selected groups of informal firms in Sri Lanka were provided information about the registration process

and reimbursement of the direct costs of registration, their registration rate did not increase (de Mel, McKenzie, and Woodruff 2013).

Such modest impacts have been observed not only in interventions targeting small firms but even in reforms that could potentially affect a much larger range of firm types. For example, a large-scale reform in Mexico that reduced the number of days taken to start a business from 30 to 1 increased firm registration by only 5 percent (Bruhn 2011; Kaplan, Piedra, and Seira 2011).

Even if firms can be induced to formalize if compensated sufficiently for the registration expenses, few appear to benefit much from registration. This finding suggests that most informal firms do not have much to gain from registering formally. In the Sri Lankan randomized study, when given payments equivalent to one-half a month to one month of the median firm’s profits, one-fifth of the firms registered. Raising the payment amount increased the registration rate. Within 15–31 months, the firms that had been induced to register had higher mean profits, but this was driven by a few select firms that grew rapidly after registration (de Mel, McKenzie, and Woodruff 2013).

This heterogeneity in the potential to benefit from formalizing may partly derive from differences in the personal characteristics of informal business owners. In Sri Lanka, 70 percent of informal business owners have personal characteristics similar to wage earners, and 30 percent are similar to formal business owners (de Mel, McKenzie, and Woodruff 2010). In Mexico, relative to informal business owners who shared personal characteristics with formal business owners, informal business owners who shared characteristics with wage workers were much less likely to formalize in response to a licensing reform and more likely to become wage workers (Bruhn 2013).

Though business entry reforms have not delivered on the promise of making informal firms formalize and grow, it would be premature to disregard such reforms. First, it is possible that there are significant hidden costs of business entry that are not being addressed in licensing reforms. Second, making entry more accessible to ordinary firms may have other positive impacts on aggregate productivity by increasing competition and efficiency in the formal sector (Charlot, Malherbet, and Terra 2015; Ulyssea 2018). This may create better employment opportunities for workers who are stuck in precarious jobs in the informal sector. Such indirect impacts of entry reforms on the informal sector are not well researched in South Asia.

REFORMS TO ECONOMIC DISTORTIONS: SIZABLE IMPACTS ON THE INFORMAL SECTOR

Although the direct impacts of regulatory reforms on the informal sector may be limited to the relatively small segment of evader- and avoider-type firms, the gains in aggregate productivity that are achieved by major economic reforms may, in time, have sizable indirect effects on the informal sector. This channel is highlighted in chapter 2, which measures the magnitude and impacts of de facto entry barriers and firm-level misallocation in Indian manufacturing.23

Chapter 2 finds that more than half the current size of India’s informal sector can be explained in equal measure by entry barriers and distortions. Specifically, distorting the benchmark US economy by introducing India’s higher level of entry costs and distortions would raise the share of the informal sector to 54 percent, more than halfway to the actual share of 85 percent in India.

How can this large outcome be reconciled with the small impacts of simplifying business entry observed in randomized trials? One reason is that chapter 2 considers the broader, long-run economic impacts of addressing distortions and entry barriers and their indirect impacts on informality. These indirect impacts are caused by an increase in the aggregate productivity of the economy and the resulting price effects. Lowering entry barriers and reducing size-dependent distortions induce the most able entrepreneurs to invest in productivity-enhancing improvements and innovations, which drives out the less able entrepreneurs in both the formal and informal sectors. The indirect impact on informal manufacturing depends on the demand links with formal manufacturing.

Another reason the analysis in chapter 2 predicts a large impact from the elimination of entry barriers is that it finds the de facto firm entry cost to be considerably higher than the explicit procedural costs of business licensing. It may be that the business entry reforms investigated in randomized studies have had a limited impact on de facto entry barriers. This suggests that policy makers should advance beyond business licensing reforms and address other access costs, such as the cost of procedures to obtain an electricity connection, that may be prohibitive for small firms, or less explicit sources of entry barriers and distortions, such as corruption in regulatory enforcement.24

However, this will not be an easy agenda. First, identifying specific sources of entry barriers and size-dependent distortions is a challenge. In their survey of recent research on distortions and productivity, Restuccia and Rogerson (2017) note that the specific policies and regulations identified in this body of research as causes of distortion do not explain a large share of the observed magnitudes of distortion. Second, even if the sources of distortions were identified, efforts to tackle them could run into opposition from powerful groups with vested interests.

Specific sources of direct and indirect distortions may reside, for example, in tax systems. Because taxes on corporate profits, sales, or value added increase the ongoing costs of formality, a reduction in tax rates might reduce informality by making formalization more attractive.25 Changes in the tax structure, too, can have an impact on the informal sector. An important development in this respect is the replacement of the sales tax by the VAT in much of South Asia. Indian states gradually replaced sales taxes with the VAT during 2002–14. Building on these reforms, in 2017, India adopted a nationwide unified goods and services tax (GST), which is structured as a VAT. The stated objectives of this tax reform included the expansion of the tax net among informal firms and growth in the manufacturing sector (KPMG 2017; Rao and Mukherjee 2019).

The VAT eliminates cascading or double taxation along the value chain, potentially reducing the deadweight losses from taxation and making formalization more attractive.26 Chapter 3 examines this channel in the case of the introduction of the