Monday, May 7, 2012

Cost of informality to Nepali economy

Published in Republica, May 5, 2012, p.8.

Cost of informality

The Ministry of Finance (MoF) and National Planning Commission (NPC) are busy sketching budget boundary for various ministries and allocating development expenditure for next fiscal year, which starts from July 16. The size of budget is expected to be over Rs 400 billion, up Rs 385 billion in 2011/12. The government meets its expenditure from domestic revenue, internal borrowing and foreign aid. The most important one here is domestic revenue, which is low at 15.2 percent of GDP (tax and non-tax revenue at 13.1 percent and 2.2 percent respectively of GDP). But, expenditure stands at 23 percent of GDP, with over half of it as recurrent expenditure. Hence, there is always a pressure to increase revenue to cover increasing expenditure. A slew of policy measures ranging from increasing taxes and customs tariff to widening tax net are implemented to achieve revenue target. However, a crucial aspect mostly ignored by policymakers is the inability to bring in informal sector inside the tax bracket and level the playing field for both formal and informal sector firms.

Now, you might be wondering what informality has to do with the economy at this point of time. Well, brining informal activities and transactions under the tax net would help increase tax revenue even when the existing tax rates are unchanged, create level playing field for formal sector firms, and boost industrial capacity and productivity. Informality is highest in services sector, particularly construction, wholesale and retail trade, hotel and restaurant, and real estate, renting and business activities, whose combined contribution to GDP is approximately 31 percent. Nepal Informal Survey 2009 shows that nearly half of informal firms produce or sell food and beverages and the rest engage in repairing, tailoring and furniture business, among others. Almost 67 percent of informal firms are in Central Development Region.

Firms operating in the informal sector have cost advantage as they avoid taxes and regulations, which the formal sector firms have to pay and abide by. They evade fiscal and regulatory obligations, including value-added tax (VAT), income taxes, labor market obligations (such as social-security deductions and minimum-wage requirements), and product market regulations (quality standards, copyrights, and intellectual-property laws).The evasion of taxes and infraction of regulations help them offset the cost of low productivity and small-scale production. [Here, let me emphasize that the tax evaders in the formal sector should not be spared in any pretext and be penalized according to the law.] The government should play an active role in bringing informal firms into the formal sector because even if the economy grows, it is less likely that the transition would happen automatically.

It is estimated that the size of informal economy (also termed “shadow economy”, which means all market-based legal production of goods and services that is deliberately concealed from public authorities) in Nepal was 37.5 percent of GDP in 2007, which is the third highest in South Asia. Sri Lanka has the highest size of shadow economy at 47 percent of GDP. No wonder formal sector investors complain that the biggest obstacle to investment climate in Sri Lanka is the unfair competition with large informal sector. A 2009 survey shows that 49.4 percent of firms compete against unregistered or informal firms and around 18 percent identify practices of competitors in the informal sector as a major constraint to doing business in Nepal. Furthermore, recent estimate of informal trade along the porous Nepal India border shows that the total value of informal imports of agriculture goods from India is approximately Rs 55 billion.

The large informal economy and trade means lower revenue receipts than the potential level, which would in turn heap additional burden on those who operate in the formal economy and also negatively impact economic growth. First, high degree of informality stifles economic growth rate, which has been suppressed below 5 percent. With ever-increasing expenditure, low tax receipts would mean either rise in taxes imposed on formal businesses or high internal borrowing. Raising taxes on formal businesses would discourage investors because they feel burdened when compelled to cough up extra money for the excesses of competitors in the informal sector. It means investment and employment generation below the potential level. Also, high internal borrowing would increase budget deficit, which stands at around 3.8 percent of GDP. Second, the high degree of informality means a weak industrial sector due to subscale and unproductive companies. Most of the informal sector companies cannot grow beyond a certain limit because of a lack of access to credit, marketing and managerial weaknesses, and absence of downstream linkages to both formal and informal firms. Worse, informal firms eat away market share of bigger and productive formal competitors as they have the advantage of avoiding taxes and regulations. It has been found that the informal companies operate at just half the average productivity level of formal companies in like sectors and have price advantage of over 10 percent. It distorts competition, leads to stunted growth of industrial sector, and restrains consolidation of firms that could have resulted in economies of scale and enhanced productivity. Also, labor rights are not guaranteed in the informal sector, workers are underpaid and working condition is much worse than in comparable formal sector firms. In 2009, average monthly salary in informal sector was Rs 3,944 while the formal manufacturing firms offered Rs 6,510 per month.

It in the interest of government to reduce informality, increase revenue by broadening tax net rather than increasing taxes on the formal sector firms only, and create a level playing field to foster competition among firms in same sectors. However, doing so is a Herculean task for the Inland Revenue Department, the main agency to collect taxes for the government, because of its limited capabilities and resources. The major driving forces toward informality are high direct and indirect taxes, the regulatory capabilities of government along with the state of formal economy, and labor market regulations. There is a disincentive to comply with all legal obligations because of poorly staffed and organized government enforcement agencies, weak penalties for noncompliance, and ineffective judicial system. In 2009, approximately 46 percent of informal firms did not get registered because they saw no benefit from it. Moreover, the high cost of operating in the formal sector deters willing informal firms to comply with formal sector regulations. These include red tapes, high tax burdens, inadequate supply of infrastructure, and meeting costly product quality and worker-safety regulations. For instance, one of the major reasons behind the high informal imports from India is the red tapes and hassles at custom points.

The government could reduce informality by reducing the cost and burden of meeting formal sector regulations and by offering enticing incentives to those that operate in the formal sector. Some of these could be strengthening enforcement of laws and regulations, eliminating red tape, and cutting prohibitively high taxes. It could also enhance its audit capabilities, make court systems fast and efficient, avoid giving tax amnesties, hike penalties for tax evaders, collaborate with financial institutions to maximize monetary transactions of firms, streamline regulatory burden, introduce electronic tax filing, and simplify tax codes. Importantly, it could initiate steps in liking informal sector with formal one so that more firms are covered in the tax net and more revenue is generated to cover rising expenditure.