Friday, March 23, 2012

The cost of informality in economy

Here are excerpts from an interesting piece on the increasing size of informal economy. Informal companies have substantial cost advantage by avoiding taxes and regulations, which in turn offsets the cost of their low productivity and small scale production. Informality is highest in services sector, particularly retail business.

Diana Farrell, director of the McKinsey Global Institute and a principal in the San Francisco office, argues that informality stifles economic growth (reducing tax receipts of governments, which then must raise the tax rates imposed on formal businesses) and productivity by keeping companies subscale and unproductive (operate at just half the average productivity level of formal companies in the same sectors), and aid companies to take market share from bigger, more productive formal competitors (as the cost benefit of avoiding taxes and regulations often amounts to more than 10 percent of the final price). Farrell argues that the assertion that informal businesses might grow and join the formal economy is a myth.

Btw, the size of shadow economy/informal economy in Nepal in 2007 was 37.5 percent of GDP.

Anyway, below are excerpts from the MGI’s analysis on informality:

MGI found that the substantial cost advantage that informal companies gain by avoiding taxes and regulations more than offsets their low productivity and small scale. Competition is therefore distorted because inefficient informal players stay in business and prevent more productive, formal companies from gaining market share. Any short-term employment benefits of informality are thus greatly outweighed by its long-term negative impact on economic growth and job creation.

Informality is among the most seriously misunderstood of all economic issues. Informal companies evade fiscal and regulatory obligations, including value-added taxes, income taxes, labor market obligations (such as social-security taxes and minimum-wage requirements), and product market regulations (including quality standards, copyrights, and intellectual-property laws). Evasion varies by sector and by the nature of the business: informal retailers tend to avoid paying value-added taxes, informal food processors to ignore product quality and health regulations, and informal construction firms to underreport the number of employees and hours worked.

For many people, the informal economy means street vendors and tiny businesses, and it is true that informality is pervasive among small, traditional concerns with low levels of technology, scale, and standardization. But it is hardly unknown among larger, modern enterprises in developing countries, where MGI has found informal supermarket chains, auto parts suppliers, consumer electronics assemblers, and even large-scale industrial operations.

The extent of informality varies from industry to industry. It is greatest in service businesses such as retailing and construction, in which companies are often small in scale and geographically dispersed, making it easier to avoid detection. Revenues come from individual consumers and are difficult for auditors to verify. Labor costs are a significant share of total expenses, so companies are tempted to underreport employment. In one country, MGI found that construction workers ran away from sites when government inspectors appeared.

For similar reasons, informality in manufacturing industries is more prevalent in labor-intensive sectors such as apparel and food processing than in capital-intensive ones such as automotive assembly, cement, oil, steel, and telecommunications. Even so, some very large industrial and manufacturing companies operate informally. In India and Russia, for instance, local governments force local power companies to provide free energy to some businesses; subsidies such as these allow informal businesses to continue operating.

Reasons for informality:

  • Legal obligations—a result of poorly staffed and organized government enforcement agencies, weak penalties for noncompliance, and ineffective judicial systems.
  • High cost of operating formally: red tape, high tax burdens, and costly product quality and worker-safety regulations all prompt businesses to operate in the gray market.
  • Social norms: In many developing countries, there is little social pressure to comply with the law. In some, many people see evading taxes and regulations as a legitimate way for small businesses to counteract the advantages of large, modern players.

How to control informality?

  • Strengthen enforcement: (regulatory loopholes are less important than strengthening enforcement). So, beef up government's audit capabilities; make court system effective so that tax evaders are caught in net; don’t give tax amnesties (more incentive to evade tax if there are repeated amnesties); hike penalties for tax evaders; partner with payments providers such as banks and credit card companies to increase the number of monetary transactions
  • Eliminate red tape: Streamline the regulatory burden and reduce red tape; simplifying the tax code
  • Cut taxes: Reduce and redistribute the tax burden to help slow the growth of informality; raise collections from  informal enterprises