How to formalize the informal sector

Forum on the informal enterprise in Pakistan (Photo: CIPE)

Over the last three decades, the informal sector in Pakistan has grown faster than the formal economy. Although estimates vary, the  informal sector accounts for at least one-third of the country’s gross domestic product (GDP). It is also an important source of employment, second only to agriculture in terms of the number of jobs. Given this dynamic growth and size of the informal sector, it is important to understand the reasons why so many entrepreneurs are unable to enter the formal economy and how to address such problems.

That was the topic of last week’s discussion forum on “The informal enterprise in Pakistan: challenges for growth” organized by CIPE and the Karachi Chamber of Commerce and Industry.  The forum gathered 40 private sector stakeholders including Karachi Chamber members, representatives from the State Bank, microfinance institutions, informal businesses, and the media.

“Research has consistently shown that entry barriers such as lengthy registration requirements, licensing and inspection requirement, and complicated taxation policy are the key reasons for people remaining in the informal sector,” said CIPE Regional Director Andrew Wilson.

Other speakers noted that the policy environment leading to the prevalence of the informal sector suffers from weaknesses in three key areas: taxation, regulation, and private property rights.

When taxes are too high, business regulations too onerous, and private property rights inaccessible for many or poorly protected, businesses that would otherwise enter the formal economy cannot overcome those barriers. That is why, as Businessmen Group Chairman Siraj Kassim Teli suggested, joint advocacy efforts by the private sector are needed to improve Pakistan’s policy environment and encourage more informal businesses to formalize.  

The participants agreed on the following key recommendations:

  • CIPE and business community represented by the chambers and trade bodies should join hands in identifying the clusters where the informal enterprises are likely to be based and should encourage, facilitate, and coach them to become a part of the formal sector.
  • The debate on the informal sector should move beyond the traditional equating it with ‘black economy’ that implies criminal endeavors. Policymakers and private sector actors alike need to acknowledge that the vast majority of informal enterprises are involved in legitimate economic activities that should be classified as ‘extra legal,’ not ‘illegal.’
  • The State Bank has introduced the Credit Guarantee Scheme for commercial banks to cover the default risk of borrowing entrepreneurs – including those in the informal sector – for up to 60% of first loss. There is a need to raise awareness among the commercial banks and enterprises to utilize this scheme.
  • The State Bank prudential regulations governing collateral requirements have been relaxed to accept any documented property including their inventories, moveable property, and receivables and more entrepreneurs should take advantage of this new lending opportunity.
  • Informal enterprises operating in the manufacturing sector should be encouraged and facilitated to use the testing, standardization, and quality assurance services offered by the government to improve their product and market development capacity.
  • A dialogue with the policymakers, regulators, and other relevant government agencies is needed to apprise them of the dynamics of the informal enterprises and the barriers they face.
  • More research needs to be done to understand the profile and characteristics of the informal sector.

Informality persists and expands because of legal barriers to entry and exit and imperfect market conditions in the face of ever-increasing consumer demand. While the informal sector enterprises may offer short-term benefits to market participants, a large informal sector drains the economy in the long run. Thus it is the joint responsibility of the government and business associations to create an enabling environment to absorb the informal enterprises into the mainstream, formal sector of the economy.

One Response to How to formalize the informal sector

  1. Huzaifa! Immaculately written article. CIPE Pakistan! Keep up the good job.