Recent popular microcredit programs and technical assistance provided by the government have helped to boost the size of the informal economy or the ‘grey’ market. Governments seem to subscribe to the view that the ‘grey market’ really creates jobs and helps to relieve social tensions. Well, does it really !

The informal economy or the ‘grey market’ generally refers to organisations engaged in perfectly legitimate business activities but somehow deliberately do not comply with tax and regulatory obligations; it does not include drug cartels, prostitution and illegal gambling operations.

Friedrich Schneider, a leading researcher for the World Bank estimates in his 2002 survey of 110 countries that the informal economy generates up to 40 percent of the GNP of low-income nations and 17 percent of the GNP of high-income ones. In some industries like construction and retailing where seasonal employment is more common, informality can account for up to 80 percent of employment. It is well known that some companies run their operations partially or wholly outside regulatory parameters by using several expedients like underreporting employment, avoiding contributions to pension funds and tax avoidance schemes, infringing product quality norms and intellectual property rights, paying lip service to health, welfare and safety regulations, and even failing to register as legal entities. The problem is reportedly acute in developing countries, but it is also widespread in some developed nations.

■ <B>An unemployment panacea?</B>

In the emerging markets the governments view the informal economy as a quick solution to a social issue and fail to understand its damaging effect on productivity and economic growth. The informal economy, they believe, creates jobs for the unskilled or laid off workers from closing factories and relieves all the tensions associated with unemployment. Some experts even argue that the informal economy will die a natural death over time as the formal manufacturing and service sectors grow and create more jobs. Other experts equally believe that the informal sector will eventually merge with the formal economy if given larger tax benefits and greater technical assistance.

Leading research institutes like McKinsey have found that the informal economy is actually growing in many countries including China, Brazil, India, Poland, Portugal, Russia, and Turkey. They have conclusively proved that that the substantial cost advantage that informal companies gain by avoiding taxes and regulations more than offsets their low productivity and small scale. The level of competition is consequently distorted because inefficient and informal players stay in business and prevent more productive, formal companies from gaining market share. Any short-term employment benefits gained through the informal economy are thus considerably outweighed by its long-term negative impact on economic growth and job creation.

■ <B>That thin grey line</B>

The ‘grey market’ happens to be one of the most seriously misunderstood of all economic issues. Informal companies routinely practise evasion on a wide and ever-increasing scale: fiscal and regulatory obligations, including value-added taxes, income taxes, labour market regulations, pension regime contributions and, wherever applicable, minimum-wage requirements, product market regulations, quality standards and health regulations, copyrights, and intellectual-property laws. The type and degree of evasion can vary by sector and by the nature of the business: informal retailers and street vendors tend to avoid paying value-added taxes, informal food processors ignore product quality and health regulations, and informal construction firms underreport the number of employees and hours worked.

For many of us, the informal economy conjures up images of street vendors and tiny businesses and family-run businesses. It is true that informality is pervasive among small, traditional concerns with low technology, scale, and standardization. But this phenomenon is hardly unknown among larger, modern enterprises in developing countries in informal supermarket chains, auto parts distributors, consumer electronics assemblers, and even large-scale industrial operations.

Informality in manufacturing industries seems more prevalent in labour-intensive sectors such as apparel and food processing than in capital-intensive ones such as automotive assembly, cement and telecommunications. According to the World Bank and the ILO, in Sub-Saharan Africa, the estimated share of informal non-agricultutal workforce accounts for up to a stunning 80 percent and 70 percent in India, Pakistan, Indonesia and the Philippines.

■ <B>Informality and its consequences</B>

The most obvious factor contributing to informality seems to be the limited enforcement of legal obligations – a result of poorly staffed and organized government enforcement departments, weak penalties for noncompliance, and ineffective judicial systems. A second factor is the overburdening cost of operating formally: too much red tape, high tax burdens, and costly product quality and worker-safety regulations all prompt businesses to operate in the grey market. Finally, cultural pressure and social norms exarcebate the problem. In many developing countries, there is little social pressure to comply with the law. In some countries, many people even see evading taxes and regulations as a perfectly legitimate way for small businesses to counteract the advantages of large, modern players with unlimited leverage.

The informal economy then is growing. The temptation stems from high tax burdens, restrictive employment laws and cuts in government enforcement budgets – sometimes the result of fiscal-austerity measures required by the International Monetary Fund and other international lenders. The debilitating and stifling effects of the informal sector on economic growth and productivity can be considerable in many ways: first, the powerful incentives and dynamics that tie companies to the grey economy keep them substandard and unproductive. Second, the cost advantages of avoiding taxes and regulations help informal companies take market share way from bigger, more productive formal competitors. Also, the adverse consequences of informality are not solely economic; they are social as well.

Once a business decides to operate informally, it is caught in a spiralling, vicious circle. Since many informal companies are hardly legal entities, they can rarely borrow from Banks and instead rely on loan sharks that charge exorbitant rates and advance the borrowed amounts in driblets. Informal businesses cannot rely on the legal system to enforce their contracts, protect property rights, or resolve disputes, so it is risky for them to engage in transactions with parties outside their immediate community. They create their own cartels of moneylenders, buyers and suppliers and networks of distribution systems. Customers of an informal business are used to expect very low prices, and many would go elsewhere if it transformed itself into a formal company and had to raise them. Pervasive informality acquires a life of its own and informal companies enjoy huge informality-related cost advantages over formal businesses. They can afford to survive despite their low productivity. In many parts of Asia, informal companies appropriate innovations and copyrights without paying for them, reducing the revenues of formal companies. It is believed that if software piracy rates were reduced to US levels, the industry’s productivity and profitability would soar by nearly 90 percent!

A vicious cycle emerges: higher taxes prompt enterprises to operate informally, raising the tax burden on the remaining formal companies, which already pay more than 80 percent of the taxes in most developing nations. This dynamic explains in part why the informal economy is growing in Brazil, notwithstanding a decade of economic liberalization and reform.

Informality also prevents larger, more productive formal companies from gaining market share. The cost benefit of avoiding taxes and regulations often amounts to more than 10 percent of the final price. That advantage leaves informal businesses – despite their low productivity – free to undercut their formal competitors and to disrupt the normal competitive process, in which more productive companies capture market share and replace less productive ones.

Leading research institutes have also found that across the developing world, formal companies are at a disadvantage. In Russia, informal food retailers gain an estimated 13 percent price advantage over supermarkets by underpaying taxes and buying goods from informal suppliers. If these retailers complied with their legal obligations, they would be at a 5 percent price disadvantage to modern supermarkets. Informality thus prevents supermarkets from gaining market share and discourages global retailers from making investments and bringing in new technology and best-practice operating methods.

■ <B>The social costs of the informal economy </B>

Most developing countries that have attained some stage of economic maturity can afford generous social-security plans and employment rules for workers. The problem is that these provisions apply to only people employed by the public sector and formal companies. The employees in the informal economy earn, on average, lower wages, receive poorer health welfare and safety protection, and have no opportunity to unionize.

Consumers have also end up with fewer choices. In developing countries, they can afford to typically buy either very expensive, high-quality goods and services like those found in rich countries or cheap, low-quality goods and services from informal enterprises and that often, without any knowledge of the hazards and risks. So consumers are compelled to choose from either end of the spectrum of the goods and services market: high or low quality, feast or near-famine. Goods and services targeted at the middle market are non-existent. The small and midsize businesses that might develop products to meet the needs of middle-market consumers are mostly informal, lacking the ability and incentives to fill the gap.

■ <B>It’s up to the policy makers</B>

Is it cheaper to compensate laid off workers with cash benefits and retraining packages or is it better to work in obsolete industrial plants with nowhere to go ?

Governments often underestimate what they can and must do or lack the political will to correct and address some of the sources of informality: high tax burdens, complex tax systems and regulations, weak enforcement, and social and cultural norms. Merely collecting taxes from more companies could well enable a government to cut tax rates without reducing its tax revenue. McKinsey has found that in Turkey, for instance, the state collects just 64 percent of the value-added-tax (VAT) revenue it is owed on retail sales. If it increased enforcement and collected 90 percent, the VAT rate could be lowered from 18 percent to 13 percent without decreasing government revenues.

To avoid sudden and massive fluctuations in employment, informality can be addressed one sector at a time. It is a fact that no emerging market has ever successfully tightened enforcement of all legal obligations for all sectors simultaneously. Biggest gains come from reducing informality in those where informal players compete directly with formal ones and have a large unearned cost advantage or where increased enforcement has a ripple effect on the rest of the supply chain. The collection of retail value-added taxes is a good place to start, since it enables the government to gain information about the revenues of the companies that supply the retailers and therefore improves enforcement among suppliers as well.

In most countries, the informal economy thrives because of weak enforcement, not regulatory loopholes. The first step, therefore, is to add resources and beef up government’s audit capabilities. Tax amnesties, as the lessons from Turkey’s ten tax amnesties and five social security amesties from 1983 have shown, makes enforcements more difficult since companies appetite for amnesties increase and they just wait for the next amnesty to come.

Reducing red tape and streamlining the regulatory burden and can also promote enforcement. Registering a new business, for example, is an onerous process in many countries. A noted economist and author, reports that it takes an average of 549 days to register a new bakery in Egypt. When businesses fail to register as legal entities, collecting taxes and enforcing regulations become difficult, if not impossible. Empowering local governments can help. In Turkey, most businesses – even informal ones – register, mainly because the municipal authorities, starved of resources, are vigilant about collecting the fees. This is a good first step that will make it far easier for the country to improve enforcement.

Simplifying the tax code can also make it easier to enforce. Spain’s innovative code for small and midsize businesses varies by sector and relies on their physical characteristics rather than their reported revenue, which is difficult to verify.

Finally, governments in emerging markets must consider reducing and redistributing the tax burden to help slow the growth of informality. Many developing countries have large state sectors and generous social programs similar to those in rich countries. It may be unrealistic, and even unfair, to expect developing countries to reduce their government spending dramatically. Still, high taxes are a huge encumbrance on formal enterprises and are correlated with high levels of informality.

Prevailing and persistent myths keep developing countries from addressing the inherent problems of the informal sector. Any serious attempt at diminishing its size would, in almost every case, remove barriers to growth and development and generate sizable economic gains. Reducing the level of informality is no easy task and carries risks that can be considerable. But by addressing the root causes of informality – weak enforcement, the high cost of operating formally, and injurious social norms – governments can attack the problem and reduce the possibility of further social disruption and inequality.

<B>Dr Dinesh MOONSHIRAM

[email protected]</B>