The Demand for, and Consequences of, Formalization Among Informal Firms in Sri Lanka

By S. D. Mel, David J. McKenzie, Christopher Woodruff. Social Science Research Network, 2012

376 citations recorded by the source corpus.

The majority of firms in most developing countries are informal. The authors of this paper conducted a field experiment in Sri Lanka that provided incentives for informal firms to formalize. Offering only information about the registration process and reimbursement for direct registration costs had no impact on formalization. Adding payments equivalent to one-half to one month's profits for the median firm led to registration of around one-fifth of firms. A larger payment equivalent to two months' median profits induced half the firms to register. The main reasons for not formalizing when offered incentives included issues related to ownership of land and concerns about facing labor taxes in the future. The degree of bureaucracy in the registration process also seems to matter for those with the incentive to register, with response to the incentives higher in Colombo, where the registration process was easier, than in Kandy. Three follow-up surveys, at 15 to 31 months after the intervention, measure the impact of formalizing on these firms. Although mean profits increased, this appears largely due to the experiences of a few firms that grew rapidly, with most firms experiencing no increase in income as a result of formalizing. The authors also find little evidence for most of the channels through which formalization is hypothesized to benefit firms, although formalized firms do advertise more and are more likely to use receipt books. In qualitative interviews owners of formalized firms also feel their businesses have more legitimacy. Finally, formalizing is found to result in a large increase in trust in the state. Their focus is largely on the private costs and benefits of existing firms formalizing. Within their sample they cannot measure broader impacts of formalization on other firms (who may prosper from not having to compete against informal firms not paying taxes), nor impacts of easier formalization on entry of new firms. Nevertheless, our results suggest that although most informal firms do not want to formalize, given the current private costs and benefits of formalizing, policy efforts that lead to relatively modest increases in the net benefits of formalizing would induce a sizeable share of informal firms to formalize.

Subfields: Accounting, Economics and Econometrics

View Paper: https://www.semanticscholar.org/paper/1b5681d8e07093a0d8585fead93fe7d9e844e21f

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Citations in the corpus

Do Interventions Targeted at Micro-Entrepreneurs and Small and Medium-Sized Firms Create Jobs? A Systematic Review of the Evidence for Low and Middle Income Countries (2014, background): “A notable exception is De Mel et al. (2013b).”
Firms, Informality, and Development: Theory and Evidence from Brazil (2018, background): “The firm-level results are related to a literature stream that uses micro data to analyze the impact of different formalization policies in developing countries, among others: Monteiro and Assunção (2012) and Fajnzylber et al. (2011), who analyze tax reduction and simplification; Bruhn (2011), Kapla”
A Helping Hand or the Long Arm of the Law? Experimental Evidence on What Governments Can Do to Formalize Firms (2013, positive): “But evidence from other countries (McKenzie and Sakho, 2010; de Mel et al, 2012) suggests that while some informal firms benefit from formalizing, the majority appear not to.”
Closing the Credit Gap for Formal and Informal Micro, Small, and Medium Enterprises (2013, neutral): “18 Such studies include Oviedo et al. (2009), Bruhn (2012), Amin (2009), Straub (2005), Maloney (2004), and de Mel et al. (2012a).”
Informal entrepreneurship and institutional theory: explaining the varying degrees of (in)formalization of entrepreneurs in Pakistan (2016, background): “In Sri Lanka, de Mel, McKenzie, and Woodruff (2013) find that just 17% of informal entrepreneurs understood the registration process believing that it took a month to register a business whilst in practice it takes a week or less.”
Taxing the Informal Economy: The Current State of Knowledge and Agendas for Future Research (2014, methodology): “Finally, de Mel et al. (2012) find that in Sri Lanka the formalisation of firms, including entrance into the tax net, fostered expanded trust in the state, even where the firms did not increase their profitability.”
Informal Entrepreneurship in Developing Economies: The Impacts of Starting up Unregistered on firm Performance (2017, background): “Second, the benefits of registration need to be enhanced, although De Mel et al. (2012) in Sri Lanka find that even a financial offer equivalent to 2 months’ profits led to only 50% of firms registering.”
Informality and Development (2014, background): “De Mel, McKenzie, and Woodruff (2013) report that information about the registration process and even actual reimbursement of direct costs of registration had no effect on formality.”