To Formalize or Not to Formalize? Comparisons of Microenterprise Data from Southern and East Africa

38 Pages Posted: 14 Sep 2009

See all articles by Alan Gelb

Alan Gelb

World Bank

Taye Mengistae

World Bank

Vijaya Ramachandran

Center for Global Development

Manju Kedia Shah

World Bank

Date Written: July 20, 2009

Abstract

Why do firms choose to locate in the informal sector? Researchers often argue that the high cost of regulation prevents informal firms from becoming formal and productive. Our results point to a more nuanced story.

Using data from surveys of microenterprises in South Africa, Namibia, Botswana, Kenya, Uganda, Tanzania, and Rwanda, we find that the labor productivity of informal firms is virtually indistinguishable from that of formal firms in East Africa, but very different in Southern Africa. We provide a theoretical model to explain this result, based on the key assumption that firms may evade taxes subject to a cost (or concealment cost) that is increasing and convex in the firm’s employment size. Consequently, the productivity distributions reflect the differences in concealment costs and the opportunity cost of formality. Greater enforcement of laws and better provision of services such as finance and electricity to formally registered firms in Southern Africa means that firms are more likely to register; those that do not are likely to be operating as “survivalist” firms. But in East Africa, weak enforcement of tax payment and no significant difference in access to services between formal and informal firms means that these variables do not explain the allocation of firms across the informal-formal divide.

We conclude that in countries with weak business environments, informal firms are just as likely as formal firms to increase their productivity as they grow. Thus, interventions to increase productivity and lower the cost of formality may be helpful. But in countries with strong business environments such as those in Southern Africa, owners of informal firms are likely to be better off entering the labor market as wage labor. In the latter case, investment in education or vocational training is probably more important.

Keywords: microenterprise, informal sector, Southern Africa, East Africa, formalization, regulations

Suggested Citation

Gelb, Alan and Mengistae, Taye Alemu and Ramachandran, Vijaya and Shah, Manju Kedia, To Formalize or Not to Formalize? Comparisons of Microenterprise Data from Southern and East Africa (July 20, 2009). Available at SSRN: https://ssrn.com/abstract=1473273 or http://dx.doi.org/10.2139/ssrn.1473273

Alan Gelb (Contact Author)

World Bank ( email )

1818 H Street, N.W.
Washington, DC 20433
United States

HOME PAGE: http://econ.worldbank.org/staff/agelb

Taye Alemu Mengistae

World Bank ( email )

1818 H Street, NW
Washington, DC 20433
United States

Vijaya Ramachandran

Center for Global Development ( email )

2055 L St. NW
5th floor
Washington, DC 20036
United States

Manju Kedia Shah

World Bank

1818 H Street, N.W.
Washington, DC 20433
United States

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