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:

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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.

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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

Metro, flyovers, airport, and oil supply in Nepal

New initiatives to address binding constraints to growth in Nepal.

New plan for Metro Railway of 66-km network, 5 lines, 31 stations in Kathmandu. Bhoj Raj Poudel writes “the proposed 66.1-km network comprises 31 stations in total -- including transfer and ordinary stations. The main terminal of the metro will be located at Ratnapark, says the report, which is yet to be approved by DoR.” Let us hope that this project will move ahead as planned.

Construction of Baneshwor flyover within this year: Om Astha Rai writes:

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The DoR has already approved one of the four basic designs of a flyover prepared by Soil Test and AVIYAAN. "We are now preparing the DPR of Baneshwor flyover," says Dr Suman Baidya, an engineer with Soil Test and AVIYAAN.

"Before finalizing the DPR, we will also calculate the estimated cost of the whole project. As per the basic design, which was approved on March 5, the Baneswhor flyover will be 17 meters wide and 340 meters long.” The Kathmandu Valley Raod Expansion Project (KVREP) is currently building a 10-lanes road connecting Tinkune with Maitigharmandala. The Baneshwor flyover, the design of which is compatible with the new map of the upgraded Tinkune-Maitigharmandala road, will have four lanes.

Btw, 115,000 vehicles, mostly motorized two wheelers, pass through Baneshwor intersection every day. Similarly average of 6,200 pedestrians cross Baneswhor junction during peak hour.

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Meanwhile, another corrupt twist:

Pokhara airport MoU signed before calling construction bid

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In a clear case that raises question over government´s impartiality on bid invited to develop regional international airport in Pokhara, Finance Minister Barsha Man Pun was found to have signed a memorandum of understanding (MoU) with China CAMC Engineering Co, committing to support it win the tender.

The fact surfaced when Nepali Congress lawmaker Dip Kumar Upadhaya circulated the MoU at a meeting of parliament´s Public Accounts Commitee (PAC) which called to grill Tourism Ministry and civil aviation authority officials over the controversy created by short deadline to bidders.

The MoU also availed by Republica commits that "the government of Nepal shall provide CAMC the solid and substantial support" in a tender that Civil Aviation Authority of Nepal (CAAN) would call for Engineering, Procurement and Construction (EPC) contract for the regional international airport. The MoU is undersigned by Pun on behalf of Nepali government and Lui Shengcheng, regional general manager of China CAMC Engineering.

The deal was signed on September 20, 2011 at Ministry of Finance in Singh Durbar, and Energy Minister Posta Bahadur Bogati and Chinese Ambassador to Nepal Yang Houlan have also signed it as witnesses. It was following the deal that MoF had instructed CAAN to invite the bid for developing the regional airport.

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A good development:

Govt for ending IOC's monopoly in Nepali oil market: Milan Mani Shrama writes:

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In a bid to cultivate competition in petroleum exports to Nepal, the government is mulling over requesting India to allow it import fuel from any Indian oil marketing companies along with the present supplier - Indian Oil Corporation (IOC).

Presently, Indian Oil Corporation (IOC) holds supply monopoly in the Nepali market.
Ministry of Commerce and Supplies (MoCS) is pushing the issue through Nepal Oil Corporation (NOC), which is presently holding talks with the IOC to review the bilateral Petroleum Supplying Agreement that expires on March 31.

“As existing bilateral agreement signed in 2007 already allows Nepal to import fuel from any countries, we see no point in India limiting oil supply authority to IOC alone,” said a highly placed MoCS official. If required, we will also hold talks with India at the higher governmental level, said Lekh Raj Bhatta, Minister for Commerce and Supplies.

The government is raising the issue after Bharat Petroleum Corporation Limited (BPCL) - another state-owned oil marketing company (OMC) of India - formally approached the ministry, expressing interest to export petroleum products to Nepal.

This is not the first time BPCL showed interest to export fuel to Nepal. The company in 2010 had approached the Indian government to end IOC´s monopoly in exports to Nepal and open it to all oil marketing public sector undertakings.

Also BPCL is not just one company that is eying Nepal´s petroleum market. In late 2009, Essar Group -- a private petroleum group of India -- too had approached the MoCS for opening imports from private Indian suppliers as well.

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Targeted food subsidy could work in South Asia

A latest working paper (Food Price Escalation in South Asia: A Serious and Growing Concern) by Bruno Carrasco and Hiranya Mukhopadhaya of the ADB states that “a spike in the cost of food staples like rice and wheat could push tens of millions more people into extreme poverty in South Asia but food subsidies targeted at the very poorest in the region would help them cope with still-high prices”. Low income households in South Asia spend more than 50 percent of their budget on food. It also notes that while Nepal and Sri Lanka would be less affected, although a further surge in wheat prices would be especially painful for Sri Lanka, which is completely dependent on imports of the staple and has already seen prices hit historical highs in recent years.

Note that an earlier study (Global Food Price Inflation and Developing Asia) by ADB showed that a 10 percent increase in food prices will increase the number of poor people (in millions) living below US$1.25-a-day by 3.8, 0.01, 22.8, 6.7, 0.6, 3.5, and 0.2 in Bangladesh, Bhutan, rural India, urban India, Nepal, Pakistan, and Sri Lanka, respectively.

The following factors are driving poverty elasticity and may contribute to differences in elasticity indices across countries: (i) the higher inequality, the lower the price elasticity of
poverty and hence the smaller the impact on poverty ratios for any given increase in food prices (ii) the distribution of income just under the poverty line (more people just under the line, the larger the elasticity), (iii) the higher the base level of food prices, the larger the elasticity as for example a 1% change in price at $10/unit has a larger impact than 1% change in prices at $5, (iv) the level of GDP/capita with smaller elasticity for countries with higher incomes, and (v) country specifics such as the effectiveness of social security systems and other safety nets, and other cultural institutions captured by a country dummy.

Reasons for rise in food prices and inflation:

• Mostly short-term weather shocks and costlier oil account in past few years
• Rapid population growth
• Changing food consumption patterns linked to higher incomes (especially in India)
• Stagnating agricultural output

They recommend subsidizing the cost of food for the most poorest and vulnerable ones by government without putting an excessive burden on government spending. Now, that is the challenge faced by all developing countries, isn’t it? The big question is how to strike a balance between extending subsidies (temptation is always high to increase such programs for political gains) and fiscal position (more subsidies mean increase in fiscal deficit in the absence of high growth of revenues that can offset the increase in expenditure due to subsidies).

Other recommendations include boosting agriculture productivity, develop agriculture support network (infrastructure investment in irrigation and water resource management, early warning systems of flood, farm to market roads, storage facilities, and ICT for disseminating market information), getting prices right (by avoiding distortion of price signals), focusing on sustainable solution [??] (avoiding short term restrictive trade policies), effective use of monetary policy (mainly contractionary policies), and promote regional cooperation (operationalize SAARC Food Bank).

Anyway, Bangladesh has the highest weight of food on CPI. The weight of food on CPI is 42 percent in Nepal.

Food Weights in CPI (%)
Afghanistan	61
Bangladesh	58.8
Bhutan	31.7
India	46.2
Maldives	33.3
Nepal	42
Pakistan	40.3
Sri Lanka	45.5

[Here is a draft paper I wrote on high food prices and its impact on South Asia. Presentation slides here and a related article here].

29.8 percent of population below poverty line in India in 2009-10

According to the latest figures released by India’s National Planning Commission, the headcount poverty in India was 29.8 percent in 2009-10 (rural 33.8 percent and urban 20.9 percent). This is a 7.3 percentage points decline in headcount poverty between 2004-05 and 2009-10 (rural poverty declining by 8.0 percentage points and urban poverty declining by 4.8 percentage points). According to Census 2011, India had total population of 1.21 billion (rural 68.84 percent and urban 31.16 percent).

Meanwhile, the WB’s US$1.25 a day estimate puts India’s headcount poverty at 37.37 percent in 2008, down from 41.64 percent in 2005 (a 4.23 percentage points drop). When I checked the data, the WB did not compute India’s total poverty at US$1.25 a day in 2010. Anyway, it has estimates for rural India and urban India for 2010. The headcount poverty at US$1.25 a day in rural India and urban India was 34.28 percent  and 28.93 percent in 2010.

Poverty in India
NPC_March 2012		WB_Feb 2012
Poverty (%) - national poverty line (MRP method)		Poverty (%) - US$1.25 a day
Total		Total
2009-10	29.8	2008	37.37
2004-05	37.2	2005	41.64
1993-94	45.3	1994	49.4
Rural		Rural
2009-10	33.8	2010	34.28
2004-05	41.8	2005	43.83
1993-94	50.1	1994	52.46
Urban		Urban
2009-10	20.9	2010	28.93
2004-05	25.7	2005	36.16
1993-94	31.8	1994	40.77

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• Poverty ratio in Himachal Pradesh, Madhya Pradesh, Maharashtra, Orissa, Sikkim, Tamil Nadu, Karnataka and Uttarakhand has declined by about 10 percentage points and more. But, in Assam, Meghalaya, Manipur, Mizoram and Nagaland, poverty in 2009-10 has increased. Some of the bigger states such as Bihar, Chhattisgarh and Uttar Pradesh have seen only marginal decline in poverty ratio, particularly in rural areas.
• In rural areas, Scheduled Tribes exhibit the highest level of poverty (47.4%), followed by Scheduled Castes (SCs) (42.3%), and Other Backward Castes (OBC) (31.9%), against 33.8% for all classes. In urban areas, SCs have HCR of 34.1% followed by STs (30.4%) and OBC (24.3%) against 20.9% for all classes. In rural Bihar and Chhattisgarh, nearly two-third of SCs and STs are poor, whereas in states such as Manipur, Orissa and Uttar Pradesh the poverty ratio for these groups is more than half.
• Nearly 50% of agricultural laborers and 40% of other laborers are below the poverty line in rural areas, whereas in urban areas the poverty ratio for casual laborers is 47.1%. In the agriculturally prosperous state of Haryana, 55.9% agricultural laborers are poor, whereas in Punjab it is 35.6%.

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The latest Economic Survey 2011/12 released by India’s Ministry of Finance states that GDP growth rate for 2011/12 is estimated at 6.9% (factor cost at 2004-05 prices). The Indian economy is expected to growth at 7.6% in 2012-13 and 8.6% in 2013-14. Here is more. In South Asia, Bangladesh, followed by India, has the highest proportion of poor people below the poverty line of US$1.25 a day.

Here is a discussion on the poverty rate in Nepal. For Nepal, the poverty headcount at $1.25 a day (PPP) was 24.8% in 2010 [7.4 million people] and 53.1% in 2003 [13.9 million people]. It was 68% in 1995 [14.7 million people]. The headcount poverty rate based on national poverty line in 2010/11 was 24.82 percent. The poverty estimate by WB and NPC is very close in the case of Nepal. But, the one in India is quite different. The WB estimate shows that there are more people living below US$1.25 a day than India’s national poverty line (monthly per capita of IRs 672.8 in rural India and IRs 859.6 in urban India—or IRs 22.4 in rural India and IRs 28.7 in urban India ). As per Tendulkar Committee recommendations, the state wise urban poverty lines of 2004-05 are updated for 2009-10 based on price rise during this period using Fisher price indices. The state wise rural-urban price differential in 2009-10 has been applied on state specific urban poverty lines to get state specific rural poverty lines.

Food weight in overall CPI in Nepal

The weight of food in CPI is 42 percent in Nepal, which means higher food prices would affect food security and exert upward pressure on inflation. The NRB figures show that food and beverage has 46.82 percent weight in CPI in fiscal year 2010/11.The NLSS III shows that 61.5 percent of household budget is spent on food (up from 59 percent in 2003/04).  Controlling food prices and ensuring food security is good for overall CPI and development. Now, what is the government doing about it?

The table below shows comparable food weights in CPI figures.

Food Weights in CPI (%)
Afghanistan	61
Bangladesh	58.8
Bhutan	31.7
India	46.2
Maldives	33.3
Nepal	42
Pakistan	40.3
Sri Lanka	45.5

Bangladesh has the highest food weight in CPI (Bhutan has the lowest) in the region. Here is the source (see Table 8, p.19).

Changing narrative of poverty and globalization in Nepal

[It was published in Republica, March 18, 2012, p.6]

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Changing narrative

There is a tendency among development agencies and analysts to repeat same arguments regarding the state of Nepal’s development and capitalize on them to secure funding for projects. The government also goes along with similar reasoning to keep alive the stream of aid, which amounts to about one-fourth of our fiscal budget. With the evolving political and economic landscapes, the narratives are changing gradually, especially of those related to the state of poverty and globalization. The concerned stakeholders will better serve the development needs of this nation if they reconsider how they are selling arguments and development narratives henceforth.

For a long time Nepal has been projected as a country with too many poor people. The widely used benchmark for comparative poverty analysis is World Bank’s US $1.25 a day poverty line. Previously, its estimate showed that almost 53 percent of the population lived below this poverty line. The development agencies and even the government used this number to amplify results to get more funds for poverty alleviation. In order to score their point, they conveniently forgot the lower poverty estimate (30.8 percent) computed by the Central Bureau of Statistics (CBS) based on our own national poverty line. This has to change now.

The latest national poverty estimate based on the National Living Standard Survey 2010/11 (NLSS III) shows that 25.2 percent of the population lived below the absolute poverty line. Similarly, the latest US$1.25 a day poverty estimate based on data from NLSS III reveals that about 24.82 percent of the population is living below the globally comparable absolute poverty line. Furthermore, the Gini index—a popular measure of inequality—has declined from 43.83 in 2003 to 32.82 in 2010, according to WB estimates. The CBS estimated Gini index at 41.4 and 32.94 in 2003/04 and 2010/2011 respectively. Meanwhile, income or consumption of those in the middle of income deciles (i.e. middle class) has also increased remarkably.

With the latest globally comparable poverty and inequality figures, Nepal can no more be projected as the nation with extremely high share of absolute poor and increasing inequality. In fact, if we look at comparable figures, Bangladesh and India have more proportion of people below US $1.25 a day poverty line than Nepal has. Similarly, Nepal has lower income inequality than some countries in South Asia.

So, what changed? Did increased funding and development interventions work their magic when growth rate was subdued to under 4 percent? Well, the remarkable feat in reducing poverty level has more to do with the bump in household income due to rising remittance inflows than government’s or donor’s development-related interventions. In fact, the remitters did in six years what the government and development agencies could not do for decades. Of course, development interventions such as construction of rural road, improvement in agriculture production, and other interventions related to the achievement of MDGs helped, but these were effectively dwarfed by the contribution of remittances in directly increasing household purchasing power, and reducing poverty and inequality.

Between 2003/04 and 2010/11, nominal average household income and nominal average per capita income increased by 153 percent and 175 percent respectively. Furthermore, nominal per capita consumption of the poorest households increased by 165 percent while that of richest households increased by 66 percent only. Also, average household income of the poorest and richest 20 percent households increased by 297 percent and 133 percent respectively. These large bumps would have been impossible without significant remittance inflows, especially after 2000. According to the WB’s and CBS’s estimate, remittance inflows increased by 327 percent and 547 percent respectively between 2004 and 2010. With the phenomenal progress seen in these numbers, next time someone tries to score points by projecting Nepal as one of the most miserable countries riddled with desperately poor people, it would not be wholly incorrect to be a skeptic. That said, in terms of income per capita, which is different from the share of people below the poverty line, Nepal is still the second poorest (at US $644) in South Asia.

Another aspect where the prevailing narrative has to change is the one concerning the state of Nepal’s globalization. Generally, trade as a share of GDP is widely used to get a sense of the extent of globalization of a country. Using this barometer, Nepal has been projected as the most open and globalized country in South Asia (with trade to GDP ratio of about 53). However, globalization is not only about the degree of trade flows in and out of a country. It also incorporates a host of other social and political dimensions. The latest KOF Index of Globalization, which is published by KOF Swiss Economic Institute, comes handy while analyzing the economic, social and political dimensions of globalization.

The economic dimension (which has 36 percent weight on the overall KOF index) measures actual trade and investment volume as well as trade restrictions imposed by countries. Furthermore, the social dimension (38 percent weight on overall index) shows the extent of the dissemination of information via various modes, and the political dimension (26 percent weight on overall index) shows the degree of political cooperation computed by considering factors such as the number of embassies, membership in international organizations, participation in UN Security Council Missions and international treaties.

Contrary to popular belief that Nepal is one of the most open (or globalized) economies in South Asia, the KOF index of the latest year available shows that Nepal is actually the third least globalized country, followed by Afghanistan and Bhutan, in the region. Sri Lanka, followed by Pakistan, India, Maldives and Bangladesh, has the highest index value in South Asia. While Belgium and Austria are the two most globalized countries in the world, Nepal ranked 163rd out of 186 countries. Looking further into the three broad measures that are used to compute the overall KOF index, it appears that, in South Asia, Nepal has the least value in economic globalization, third least value in social globalization, and fourth least value in political globalization. The message coming out of this updated measure of globalization, which goes beyond the usual measure of openness based on trade as a share of GDP, is that Nepal cannot be portrayed simply as the most open economy in the region.

A study based on the globalization index shows that the actual economic flows and restrictions in developed countries are most strongly related to economic growth. In the meantime, while information flows are slightly less strongly related to growth, political integration has no effect. What does this mean for Nepal? Well, we have to work more on greater integration in order to have a sizable globalization-induced growth. Specifically, we have to boost actual trade and investment flows and address the factors that are hindering supply capacities, especially those related to infrastructure, strikes, labor disputes, and research and development.

With changing economic and political landscapes, the long held views about the extent of poverty and globalization in Nepal should also change. While Nepal is no more a country with the highest share of poor people below the poverty line, it still has one of the lowest per capita incomes in the region. Meanwhile, it is not the most open economy in South Asia and the potential to reap benefits from increasing degree of globalization is limited by supply-side constraints.

[Published in Republica, March 18, 2012, p.6. In the article I have mentioned income inequality (Gini index). It should have been Gini coefficient based on expenditure. Thanks to Purna Man for pointing that out.]

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Roads and apples in Mustang

Here is how road connectivity spurs local economy and production in rural areas. We have comparative advantage in the production of apples from Mustang. In fact, we have monopoly on it and producers could rake in supernormal profits as the willingness of consumers to pay relatively high prices for apples produced in Mustang is high.

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Although Mustang´s apple had carved a niche for itself in the domestic and international markets a long ago, unavailability of road network meant many farmers saw their produce go wasted unable to find market. As a result many farmers simply lost interest.

But after construction of the road in the district couple of years ago more and more farmers have started adopting apple farming as a profession once again and more land in the northwestern district is being converted into apple farms. This year alone farmers grew apple in 255 hectares of land. These farmers can earn up to Rs 1.5 million per year by selling their produce. “Traders arrive at our doorstep to collect the produce and we have no problem marketing them,” said Indra Bahadur Tulachan, a farmer from Tukuche.

According to the Mustang Agriculture Office, people who stopped apples farming because of difficulties in transportation have once again started growing apples. As more people returned to apple farming, the district faced a shortage of apple sapling this year. The demand for saplings hovers at around 20,000 units per year. However, the demand went up by around four folds this year. “To fulfill the demand we had to get the saplings from Jumla,” Meghnath Timilsina, senior official of the Mustang Agriculture Office, said.

As income from the apple business tops hundreds of thousands of rupees each year, farmers have now started running group apple farms in the district. To attract more people toward apple farming, the district agriculture office has also started providing subsidy on apple saplings, packaging and transport of apples. The office also conducts free training sessions to acquaint farmers with various technical aspects of apple farming.

Currently, around 2,000 farmers are involved in apple farming in the district.

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