The informal sector — the unlicensed, unregistered small businesses that make up the bulk of economic life in many countries — is not all bad.
A recent article in the Economist analyzed the issue of informality in the Indian economy and drew out a range of excellent points regarding the size of the country’s informal economy and the energy and dynamism that undocumented economic activity has brought to rural India, as well as the difficulties that informality can bring. These include costs to the entrepreneurs themselves, in terms of accessing credit and problems achieving scale, among others, as well as costs to the overall economy in terms of lost tax revenue and the circulation of money outside of the financial system. Indeed, there has been no shortage of research on the challenges posed by informality around the world.
What this article gets wrong however, is its conclusion, regarding what India can do to promote the formalization of the informal sector. The author writes “The best way to speed up the process is to extend the reach of the financial system. In return for coming into the formal economy and paying taxes, firms would get access to capital.” This analysis misses an important point about informality.
Lack of access to the formal financial system is a result of informality, not a cause of it. Simply expanding the reach of banks to give more access to the financial system won’t bring informal entrepreneurs out of the shadows. Of course these firms want access to capital – but it is wrong to assume that simply dangling the carrot of access to capital will cause them to rush to embrace formalization and payment of their taxes. Many of these entrepreneurs already have access to some level capital through microfinance, credit collectives, or moneylenders. Moreover, there are many places where banks have expanded their own branch network or successfully penetrated the microfinance space to reach new borrowers.
The more salient question is whether there is the volume of capital these borrowers need to grow their firms – and yes, certainly small firms want more capital. And they know that to access that capital, they need to be in the formal economy. But there are systemic, institutional reasons why they cannot do so, and thus remain informal. These include complex barriers to registration, high levels of taxation or corruption, weaknesses in contract enforcement, and lack of bankruptcy protection. These factors are particularly prevalent in India’s economy, which remains rather bureaucratized despite several decades of reform.
By tackling those issues first, informal entrepreneurs will see formalization as feasible as a business decision; only then will they have an incentive to formalize, and then to gain access to benefits of formalization, including the formal financial system.
Marc Schleifer is Regional Director for Eurasia and South Asia at CIPE.