1. Introduction
Informal
sector constitutes a large part of a developing economy. It seems that the
informal firms take a rational decision to exit from the formal domain by
comparing the costs and benefits of formalization. (Suresh De Mel, David
McKenzie, and Christopher Woodruff, 2013). De Mel and others found that
formalization has a very limited impact on the profitability of the firms who
exit the informal sector and join the formal one. Given this, we want to find out
if the push for formalization of informal firms in a developing country is of
any benefit. Here, I want to argue that any push for formalization in the
developing countries will act as a double-edged sword. In other words, it is an
act that has both favorable and unfavorable consequences. Still, I believe that
the favorable consequences of formalization outweigh its unfordable outcomes.
2.
The unfavorable consequences of formalization drive
2.1
Government might waste its budget on firms that cannot stand in the competing
world of formal sector.
Firms
which are in the informal sector can easily compete with formal sector firms
and even have an edge over them due to lower wages, non-existence of taxes and
other types of costs that are related to activity in the formal sector. In
the informal sector, they can survive even if they do not make a profit. This is
what makes activity in the informal sector favorable to informal firms.
The
firms that can survive in the informal sector might not survive once they enter
the formal sector unless there is enough financial support from the
government. If we assume that the government will support them with subsidies, then
there will not be much room to argue that formalization is good because it adds
to the income of the government. If subsidies or financial amounts are paid to induce
informal firms to become formal, then one would argue that letting informal
firms in the informal sector is better because they will not be a burden on the budget of the government. If we argue that incentives should be paid only for a
short time, then one would counter us that the firms might return to the informal
sector as soon as the government cut its financial support. Therefore, we can
say that one unfavorable consequence of push for formalization through
financial incentives is that government might waste its budget on firms that
cannot stand in the competing world of formal sector.
2.2
A large section of people might not be able to survive.
Another
somewhat obvious consequence of push for formalization is that a lot of firms
might completely die out and disappear after a while when they enter the formal
sector without any financial support from the government. Of course, here we are
assuming that the government is using force to turn the informal sector formal.
This means that a large part of people who could previously survive working in
the informal sector now even might not be able to survive.
3. The favorable consequences of formalization drive
3.1
Tax and efficient allocation of resources
Research
has shown that informality and lower tax collection are related – a phenomenon
that reduces the ability of the government to finance public services (Levy, 2008).
Hence, one favorable consequence of formalization is higher tax collection that
will enable the government to better finance public services and even invest in the development
projects. However, taking our discussions in the previous paragraph into
consideration, we should cautiously optimistic about this consequence of
formalization.
The
coexistence of formal and informal firms leads to an inefficient allocation of resources
in the economy through the different marginal production costs (Chang-Tai Hsieh
and Peter J. Klenow, 2009). Therefore, formalization will lead to efficient
allocation of resources which is another favorable consequence.
3.2
Profitability for the firms and contribution to economic growth and development
In
addition to the above, another favorable consequence of formalization is access
to formal business infrastructure including credit, technological support and
access to more markets which ultimately lead to higher productivity and output
of the firms. This favorable consequence can be viewed from the perspective of
firms, because firms which are active in the informal sector have no or very
limited access to what we just pointed out. Similarly, the firms will no longer
be subject to harassments and bullying of government authorities asking for
bribes.
We
said that formalization opens access to formal business infrastructure
including credit, technological support and access to more markets which ultimately
lead to higher productivity and output of the firms. Higher productivity means,
for the firm, higher profits and for the entire economy higher growth. Through
this channel, formalization helps an economy with its growth and development.
3.3
Impacts on the quality of life of laborers
Apart
from the above, I believe formalization will have positive impacts on the
quality of life of labor force. When informal firms are formalized, they are
required to follow labor laws set by relevant authorities. Wages of laborers
will increase and some form of protection will be provided to
employees/laborers. This is while in the informal sector, firm owner is
restricted by no law and he/she can set any wages and can hire/fire on the
spot. Of course the problems that informal sector laborers are facing are not
limited to wage and instant firing. Inhumane working conditions are another
big issue.
4.
Conclusion and my take
As
discussed above, in the case of financially incentivizing informal firms to join the formal sector, the government might waste its budget on firms that cannot stand
in the competing world of formal sector. However, there are chances that the
firms stand on their own feet and become competitive profit-maximizing firms.
If governments, backed by the use of force, coerce informal firms to go formal,
there is a risk that a large section of people might not be able to survive
when the informal sector disappears. This is firstly impossible. Even if we
assume its possibility, due to inefficient and ineffective outcomes, it is not
recommended.
Apart from the above undesired possible outcomes under certain conditions, I believe that formalization drive for informal firms in a developing country setting has various benefits. It can improve the quality of life of laborers employed by the informal sector, it can make survivalist firms profit-maximizing which contribute to the economic growth and development, it can improve the allocation of resources throughout the economy, and finally it adds to the income of the government. Hence, as stated at the opening paragraph of this writing, I believe the favorable consequences of formalization outweigh its unfordable outcomes.
References
Chang-Tai
Hsieh and Peter J. Klenow. (2009). Misallocation and Manufacturing TFP In China
and India . Quarterly Jouranl of Economics.
Levy,
S. (2008). Good Intentions, Bad Outcomes: Social Policy, Informality and
Economic Growth in Mexico. Brookings Institution Press.
Suresh
De Mel, David McKenzie, and Christopher Woodruff. (2013). The Demand for, and
Consequences of, Formalization among Informal Firms in Sri Lanka. American
Economic Journal: Applied Economics.
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