Notes

This overview chapter stresses the need for more policy research and discussion on issues that are explored in this volume.

• First, how can various types of digital platforms address market frictions that lower productivity and reduce the resilience of informal firms and workers, and what complementary interventions may be needed to unlock positive impacts?

• Second, how can new ways of gathering and analyzing data on the traits and behavior of entrepreneurs and workers be used to tailor and target programs to the heterogeneous segments of the informal sector?

• Third, how can the extreme poor who are self-employed be better served by multidimensional economic inclusion programs?

• Fourth, how can the various segments of the informal sector be provided with some form of social insurance, whether publicly or by public-private partnerships?

The studies included in this volume present some early answers on these issues, but they also raise additional questions.

1. Estimates using pooled data from the Annual Survey of Industries and the National Sample

Survey of Unincorporated Enterprises of 2015–16. In this estimate, own-account enterprises (those without any hired workers) in the National Sample Survey are considered informal firms. See ASI (Annual Survey of Industries) (dashboard), Industrial Statistics Wing, National

Statistical Office, Ministry of Statistics and Program Implementation, Kolkata, http://www .csoisw.gov.in/CMS/En/1023-annual-survey-of-industries.aspx; “India: Unincorporated

Non-Agricultural Enterprises (Excluding Construction), July 2015–June 2016, 73 round” (data portal), National Data Archive, National Sample Survey Office, Ministry of Statistics and Program Implementation, New Delhi, http://www.icssrdataservice.in/datarepository /index.php/catalog/148. 2. For example, see Lewis’s (1954) dual economy framework in which the modern (formal and urban) sector grows and absorbs workers from the shrinking traditional (informal) sector. Also see Harris and Todaro’s (1970) two-sector model whereby the minimum wage regulation in the formal sector generates excess labor supply that ends up in the informal sector. Deregulation in this model reduces informality. 3. See de Soto (1989) and Djankov et al. (2002) for examples of those who argue for an insider-outsider dualistic view of informality and Levy (2008) and Maloney (2004) among the proponents of the incentives-choice approach. For a recent excellent survey, see Ulyssea (2020). 4. A similar definition is adopted by Ulyssea (2020) in a recent literature review on informality. La Porta and Shleifer (2008, 2014) use registration with authorities in their definition of firm informality. Gelb et al. (2009) and Steel and Snodgrass (2008) use registration with tax authorities as the criterion in their definition of informal firms. They argue that the informal sector is an entity unknown to the fiscal authorities. Medvedev and Oviedo (2016) use

compliance with four regulations to identify formal firms. A firm is formal if (1) it has a tax

ID, (2) it has a municipal license, (3) it requests receipts on its purchases, and (4) the majority of its employees are registered with the social security authority. 5. A key characteristic of such enterprises is that they are unincorporated and that there is no clear separation between the assets linked to the production activity of the firm and the assets of the firm owner. 6. Given their specific institutional arrangements, other regions may emphasize different aspects of the relationship with governments to define informality. For example, in the case of Latin America, Levy (2008) explains that the relationship between employer and employee is the core criterion in distinguishing formality and informality. Workers registered for social security, no matter the size of the firm that employs them, are considered formal workers. 7. This definition is consistent with the one established by the International Labour Organization (ILO 2013), and it has also been adopted by the national statistical offices of the countries in the region. 8. See Lucas (1978). Most papers concerned with the size distribution of firms have their origins in this seminal work. 9. This is an example of a size-dependent regulation. For example, the Factory Act (1947) in India requires all manufacturing units with at least 10 workers (20, if they do not use electricity) to register with the Registrar General of Industries. These factories have to comply with certain special regulations. 10. Firms may choose to register formally, but evade labor regulations by hiring workers on an informal basis. This intensive margin of informality (Ulyssea 2020) most closely corresponds to firms in group B in the framework. 11. See, for example, Syverson (2011) for a review of the knowledge base on the determinants of productivity in firms. 12. Online lending (financial technologies or fintech) platforms that use automated processes and nontraditional creditor data to screen loan applicants and match them to lenders could help expand access to credit among informal firms that are outside the formal banking sector.

Digital task apps, such as HelloTask—the Bangladeshi app that matches women domestic workers and potential employers—may enable low-skilled workers in the informal sector to find employment that is better paying, safer, and more flexible. 13. More evidence is also needed to understand if unlocking the potential of digital platforms in the informal sector requires complementary public interventions. For example, because fintech relies on the digital footprint of firms in assessing loans, informal firms that have adopted other digital technologies, such as cashless payments or e-commerce, may find accessing fintech easier (see Ghosh, Vallee, and Zeng 2021). Government initiatives to open access to digital payments by informal firms might thereby have positive spillovers on access to credit among these firms. 14. Business training programs and grant programs in kind and in cash have been found to be cost-effective in improving the performance of informal microenterprises and small firms, though not always. Some successful program designs are also influenced by a contextspecific understanding of peer effects, gender norms, or psychological factors, such as entrepreneurial mindset. See Jayachandran (2020), McKenzie and Woodruff (2014), and

Woodruff (2018) for reviews of this evidence.

15. This recent strand of research on informality follows the literature on firm-level heterogeneity and the misallocation of resources, which is reviewed, for instance, in

Restuccia and Rogerson (2017). 16. The marginal product in revenue terms is equalized. The analysis abstracts away from this by assuming that the firms are price takers in the output market and by setting the output as the numeraire. 17. In reality, governments have multiple registration requirements, ranging from local or municipal business registration to federal tax registration. These requirements have different compliance thresholds and are associated with different types of regulatory costs and taxes.

To simplify, the framework in this chapter focuses on one major regulatory threshold. 18. Strictly speaking, firms with natural size at or slightly above Q will optimally choose to keep employment slightly below Q and avoid the regulatory costs, without any illegality on their part. This is discussed in more detail in the next subsection. 19. Business registration laws are often not enforced on microenterprises and small firms in South Asia. Sometimes, key business registration requirements and the associated regulatory costs explicitly apply only to firms above a specific size threshold. For example, in India, the Factory Act (1947) requires all manufacturing establishments employing 10 or more workers to register as factories. In other cases, even though all firms are supposed to register, the degree of enforcement intensity among small firms is practically nil.

For instance, among firms with 1–10 workers in Sri Lanka, only 5 percent reported that they had any interaction with a public official in the previous year. Among unregistered firms with 1–10 unregistered workers, fewer than 0.5 percent reported that they had to pay a fine, penalty, or bribe because of their unregistered status (de Mel, McKenzie, and

Woodruff 2013). 20. See ASI (Annual Survey of Industries) (dashboard), Industrial Statistics Wing, National

Statistical Office, Ministry of Statistics and Program Implementation, Kolkata, http://www .csoisw.gov.in/CMS/En/1023-annual-survey-of-industries.aspx; “India: Unincorporated

Non-Agricultural Enterprises (Excluding Construction), July 2015–June 2016, 73 round” (data portal), National Data Archive, National Sample Survey Office, Ministry of Statistics and Program Implementation, New Delhi, http://www.icssrdataservice.in/datarepository /index.php/catalog/148. 21. The low prevalence of avoiders does not imply that the costs associated with crossing the regulatory size threshold are trivial. Based on the observed distortion in the firm size distribution at the 10-worker threshold in India, Amirapu and Gechter (2020) estimate this cost to be 35 percent of unit labor costs. Although the threshold cost is high, the share of firms avoiding it may be low if the natural size distribution of firms is such that most firms are too small to be close to the threshold. 22. Some of the observed dispersion in value added per worker may derive from temporary idiosyncratic shocks faced by firms. 23. A fresh contribution of chapter 2 to the evidence base on informality in South Asia is that, instead of relying on measures of explicit regulatory entry costs, de facto entry barriers and distortions are quantified according to the model, combined with observed distortions in the firm size distribution and input usage patterns. Chapter 2 thereby builds on a large literature on the causes and consequences of firm-level resource misallocation.

Hsieh and Klenow (2009), for example, estimate that, if capital and labor were reallocated

as efficiently in India’s manufacturing sector as they are in the United States, the gains in manufacturing TFP would be in the range of 40 percent–60 percent. Size-dependent distortions—distortions that effectively tax a firm more and more as it grows in size— are particularly costly to productivity growth (Hseih and Klenow 2014; Restuccia and

Rogerson 2017). This is because they disincentivize firms from making investments in physical and human capital. 24. In a similar vein, Amirapu and Gechter (2020) estimate that crossing the 10-worker size threshold is associated with a 35 percent increase in de facto unit labor costs in Indian manufacturing. This high cost cannot be explained by de jure regulatory costs. 25. However, total tax revenue could decline if this increase in the tax base is not sufficiently large to offset the reduced tax incidence on already formal firms. In Brazil, for instance, a large-scale formalization program that reduced taxes after business registration costs had already been reduced led to greater formalization by informal firms, although at the cost of a loss in total tax revenue (Rocha, Ulyssea, and Rachter 2018). 26. Another channel through which replacing sales tax with a VAT can affect informality relates to the self-enforcing feature embedded in this tax system. The VAT is often implemented through a tax credit system along the value chain whereby each firm receives a tax credit for inputs purchased from upstream firms to ensure that it only pays taxes on value added.

This generates a paper trail and an incentive for firms to report purchases accurately from other firms (Pomeranz 2015). This process can lead to a transmission of formality (respectively, informality) along value chains that are already more formal (respectively, informal), as firms that are transacting predominantly with formal firms can only take advantage of the

VAT credit by becoming formal (de Paula and Scheinkman 2010). In India, the introduction of the GST had a larger impact on firm registration in industries with more backward and forward links (Hoseini and Briand 2020). 27. The new VAT rates were generally higher than previous sales tax rates. Because the VAT does not involve double taxation along the value chain, VAT rates typically need to be higher than sales tax rates to generate the same total revenue. Chapter 3 finds that, if the VAT tax rate had dropped to zero, only about 3.5 percent of informal firms would have formalized. 28. The estimation of the elasticity of sales to the tax rates is carried out by employing a difference in differences approach that compares trends in sales among firms selling products affected by a rate change versus firms not affected, before and after the rate change. 29. For instance, see Woodruff (2018) for a review of evidence on the various constraints faced by small businesses. 30. The median firm in the dataset has three employees and an estimated annual revenue of about Rs 3 million (US$40,000). 31. See Hellotask (dashboard), HelloTask Platform Ltd., Dhaka, Bangladesh, https://hellotask.app/. 32. In the United States, for example, fintech companies are a major source of loans to small firms and may have played an important role in the recovery from the 2008 financial crisis (Gopal and Schnabl 2022). In France, the use of fintech is disproportionately high in locations with fewer bank branches, lower incomes, and a larger minority share of the population, as well as in industries with limited bank lending to small businesses (Erel and Liebersohn, 2020). 33. Using data from an Indian fintech lender that serves small businesses, Ghosh, Vallee, and

Zeng (2021) find that small firms that make greater use of digital payments are more likely to be approved for fintech loans and obtain a lower interest rate.