When Formality is too Costly: An Experiment from Benin

Many economies in the developing world exhibit a dual structure: the formal sector and the informal sector. While large firms operate in the formal sphere, a majority of small- to medium-size firms operate informally. Estimates of the size of the informal economy vary, but in many countries, especially sub-Saharan Africa, the informal economy is estimated to be a non-trivial portion of GDP. With estimates as high as 60 percent of GDP, this is a substantial portion of lost tax revenue for a government. In response, governments have instituted a formalization process through business regulation reforms.

In a new study, Benhassine, McKenzie, Pouliquen, and Santini conduct a randomized experiment on one such formalization policy in Benin, a simplified legal status offered to small, informal businesses known as the “entreprenant” status. The authors test three treatments intended to encourage informal firms to register. The first treatment, the lightest of the three, provided information to firms on the entreprenant status and offered registration assistance. The second treatment included the provision of and access to training services and bank accounts. The third treatment provided tax preparation support and tax mediation services. One treatment group received basic assistance, another received basic assistance and access to training services, and the third group received all three treatments.

Theoretically, firms will formalize if the net benefits from doing so outweigh the costs, namely monetary, time and information costs. The entreprenant status lowers the cost because registration is free. However, the primary concern is the cost of taxes that many informal firms would otherwise escape. Those that do pay taxes face significant uncertainty over the amount of taxes due. The formalization policy offered businesses that were not previously paying taxes a year of tax exemption and the possibility of a 40 percent reduction in taxes over the following three years. The potential benefits of formalization are increased profits as a result of access to financial and banking services and access to new markets.

Under this framework, the authors predicted that only informal firms that are close to the margin of formalizing will formalize. Their results showed significant impacts on the formalization rate, with the largest increase for the group receiving all three treatments at 16.3 percentage points. While this impact is larger than for similar programs (Bruhn and McKenzie, 2014), most informal firms still remain informal. One explanation is the existence of other legal barriers to formalizing, such as the lack of a passport.

Next, the authors analyze the intermediate effects of formalization. Formalization increases the likelihood of attending business training in the past year and decreases perceived tax harassment, but for those groups receiving facilitated access to bank accounts, there is no significant impact of formalizing. Overall, formalization has a limited impact on intermediate outcomes that affect profitability.

Empirically, formalization does not necessarily translate into increased profits. In fact, the authors do not find significant impacts on any measures of business performance. The authors conclude that, from the government’s perspective, it may be more cost-effective to directly pay firms to formalize, as the treatments were found to be exceptionally costly. The cost of direct payment, however, offsets the boost in tax revenue for the government due to formalization. The authors calculate that it would take at least a decade for the additional tax revenue generated to recover the costs of inducing formalization.

In light of this evidence, the authors believe that encouraging formalization is not necessarily the best policy to address the informal sector. Instead, the authors suggest that targeted encouragement to those firms on the margin of formalization is a more effective and less costly policy. Furthermore, this would reduce the amount of time it takes to recoup the cost of the intervention. Informality will remain a common feature of developing countries, and policymakers must analyze the tradeoffs before inducing formalization.

Article source: Benhassine, Najy, David McKenzie, Victor Pouliquen, and Massimiliano Santini. “Does inducing informal firms to formalize make sense? Experimental evidence from Benin.” Journal of Public Economics 157 (2018): 1-14.

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