Enterprise formalization in Africa: what did we learn?

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I'm just back from our enterprise formalization conference in Ghana. We had a broad mix of policy-makers and private sector representatives from 15 African countries and a very stimulating discussion. I will be putting up some more considered reflections on the conference website later this week, once I've recovered from the jetlag. Meanwhile let me try to sum up what was said and the lessons we (think we) learned. In the process I'd like to respond to some of the points Edoardo and Chanyaka have raised in their comments on my last post.

We all agreed that the first task facing policy-makers is to identify and reach those individuals and enterprises for whom the individual and social payoffs to formalization are greatest. As Eduardo points out, many people are outside the system through no choice of their own. No doubt some informal enterprises would disappear if forced to comply with government regulation. But it would also appear that the potential for voluntary formalization is large. And there are also significant externalities to formalization - in terms of tax revenue and compliance with environmental and social regulations. We might ask: if these benefits are so large, why then is there a problem?

Part of the difficulty lies in the costs and time required for compliance. But reducing barriers to entry will only get you so far. Formalizing informal enterprises requires more than simplifying regulations – it requires us to understand the relationship between state and private business as a bargain or contract. And as with other bargains, they can be quite difficult to construct and maintain, even with goodwill on both sides.

The conference participants highlighted two issues in particular - information and trust. In many cases entrepreneurs lack even the most basic knowledge about how to regularize their enterprises or of what they might stand to gain from doing so. Similarly, governments know little about the people whom they are trying to regulate or tax. As one of the conference presenters put it:

patrolling poorer areas to identify tax evaders… is a thankless task… educated tax officials dislike interacting with illiterate, poor, disenchanted and sometimes violent citizens who dislike being harassed for taxes when they are attempting to eke out a meager living.

The second issue is trust. Many informal operators are reluctant to disclose their activities to the authorities because they fear they will be extorted for bribes. Or they may feel that they will get nothing in return for their cooperation. The key task then, is to make people outside the system understand that government can work for them. After all, states that have little to offer cannot ask for much in return. How then should policy-makers proceed?

Lesson # 1: Understand Incentives

The most basic requirement is to understand exactly what informal entrepreneurs might gain from formalizing. Their reasons for doing so are quite context-specific. In mining communities, for example, small scale operators don't usually require loans but they do require a reliable means of holding and transporting cash. Linking formalization to credit would make little sense but providing physical security might.

Meanwhile small-scale service providers, such as suppliers of electricity, sanitation and water, need a stable legal environment because they have to make fixed investments that can be easily expropriated. Their overriding concern is not infrastructure or accreditation for their products, but the legitimacy that comes with regular status.

Once policy-makers have understood what it might take to persuade entrepreneurs to formalize, they need - as Chanakya says - to think creatively about how to how to link costs and benefits. The conference threw up a few examples. In one case the government worked with commercial banks to persuade them to lower their cost of lending to enterprises that agreed to register and pay taxes. The argument was simple: formalizing sent a credible signal that the enterprise was not going to disappear overnight and therefore deserved a lower risk rating. In another case, a revenue authority allowed newly registered firms to charge higher VAT rates on their products than those they paid to their suppliers – effectively giving them a tax break in exchange for formalizing. Many policy-makers might be skeptical about making these connections, but I think it's important to put the question on the table.

Lesson # 2: Identify and Work through Intermediaries

Another lesson is to identify and work through 'amphibians' - people who have one foot in the informal sector and the other in the world of formal institutions. The advantage of using intermediaries is that they have closer knowledge of conditions on the ground and may be better placed to enforce bargains. They are also well qualified to set common industry standards and identify and punish individuals who fail to meet them, or to package information about their members and provide it to commercial banks or other service providers at a lower cost than if they did it themselves.

There are several candidates for this intermediating role. The most common are business associations. In northern Italy, artisans' associations persuaded their members to regularize by providing business development services, such as accounting and help with tax returns. In Kenya the association of small tea-growers helped its members' compliance with national product standards by acquiring inputs, such as pesticides and fertilizers, in bulk and selling them at a discount to producers.

Another possibility is trade unions - as in Ghana where a road transport union has collected taxes from its members on behalf of the state for the last twenty years in exchange for a small fee. Other potential partners include large formal firms – either individually or a part of an export processing zone, as Chanakya suggests. In Senegal, locally-owned fish wholesalers selling to European markets have worked closely with informal suppliers to help them meet export standards, for instance by providing them with ice so that their catch does not spoil en route to the processing plant and by issuing invoices on their behalf to keep track of production.

In countries where private sector activities have been disrupted by conflict it can be advantageous to work with enterprises that were previously formal and which retain a 'memory' of what it is like to operate within a regulated system.

Of course there are caveats. As in developed countries, most business associations in the developed world are dominated by large politically well-connected firms who little interest in engaging with informal enterprises. And they are often preoccupied with donor concerns, to the detriment of an independent policy agenda. Multinationals tend to depend on outside suppliers and may be reluctant to enter - unless contractually obliged to do so. Conversely local suppliers may think twice before tying their fortunes to a single buyer. But it is almost impossible, as I think Edoardo pointed out some weeks ago, to formalize enterprises that are not already organized in some fashion.

Where does this leave us? We should be realistic. The transition from informality to formality is not painless. Enforcing rules, even when they are well designed, is likely to cause disruption in the short term. And the costs are likely to be even higher if the process is poorly managed. It is preferable to begin with those for whom the potential benefits are preferable and even then to emphasize the carrot at the expense of the stick, at least at first. But this should not put policy-makers off. The longer term costs of informality are even higher – both individual and social.

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