Boost growth by reducing the informal economy

By Diana Farrell

Research by the McKinsey Global Institute has put a spotlight on one of the biggest and most misunderstood barriers to economic growth: the vast agglomeration of businesses that evade taxes and ignore regulations, often referred to as the "informal economy."

World financial leaders gathered recently in Washington for the annual meetings of the World Bank and International Monetary Fund. But missing from their agenda was one of the biggest and most misunderstood barriers to economic growth: The vast agglomeration of businesses that evade taxes and ignore regulations, often referred to as the "informal economy."

The informal economy is not just the unregistered street vendors and tiny businesses that form the backbone of marketplaces in Asia and other emerging markets. It includes many established companies, often employing hundreds of people, in industries as diverse as retail, construction, consumer electronics, software, pharmaceuticals and even steel production. In India, Pakistan, Indonesia and the Philippines, as much as 70 percent of the non-agricultural workforce is employed in informal businesses.

Despite the prevalence of the informal economy, Asian policymakers show surprisingly little concern. Some governments argue that it helps relieve urban employment tensions and will recede naturally as the formal economy develops. Development experts contend that informal companies themselves will grow, modernize, and become law-abiding if given some help. And most policymakers implicitly assume that the informal economy does no harm.

But there is little evidence to support these beliefs. Research by the McKinsey Global Institute found that informal economies are not only growing larger in many developing countries, but are also undermining enterprise-level productivity and hindering economic development.

The reasons why informal economies grow—and keep growing—are not hard to uncover: High corporate tax rates and the enormous cost of doing business legally. It takes 89 days to register a business in India, compared with eight days in Singapore. It takes 33 days to register a property in the Philippines, compared with 12 in the US. It takes five and a half years to close an insolvent business in Vietnam. All in all, emerging-market businesses face administrative costs three times as high as their counterparts in developed economies. No wonder so many choose to operate in the gray.

The costs imposed by the informal economy are not limited to the hundreds of millions of dollars in foregone tax receipts; more damaging is its pernicious effect on economic growth and productivity. The unearned cost advantage informal businesses enjoy from ignoring taxes and regulatory obligations allows them to undercut prices of more productive competitors and stay in business, despite very low productivity. Informal software companies in India appropriate innovations and copyrights without paying for them, reducing the industry's productivity and profitability by up to 90 percent. Informal apparel makers in India gain a 25 percent cost advantage over their law-abiding competitors by not paying taxes.

Informal businesses thus disrupt the natural economic evolution whereby more productive companies replace less productive ones. This discourages investment and slows economic growth. Even worse, it creates a vicious cycle in which governments increase corporate tax rates to raise revenue, which prompts more companies to evade taxes, thus causing the informal economy to grow still further.

The notion that informal companies might grow and become more productive is unfounded. They can't borrow from banks or rely on the legal system to enforce contracts or resolve disputes, and they structure relationships with informal suppliers in ways that make it difficult to come clean. In fact, informal companies often shun opportunities to grow and modernize precisely so they can continue to avoid detection. As a result, informal businesses remain a persistent drag on national productivity and living standards.

Governments are often unaware of the huge economic gains that result from reducing informality, and of what they can and must do to address its causes: high taxes, complex tax systems and onerous regulations, weak enforcement, and social norms that see noncompliance as legitimate. Addressing these problems is essential in reducing informality.

Reducing the tax burden on businesses is perhaps the most critical step to reducing informality, since high taxes increase the incentives for companies to operate informally. For many Asian governments, one path to lower taxes is through broadening the tax net: collecting taxes from more companies can enable governments to cut tax rates without reducing tax revenue, while simultaneously breaking the tax-evasion cycle.

Many Asian countries also have large governments and generous social programs similar to those in rich countries, and this poses a heavy burden on business. The Indian government, for instance, spends over 30 percent of the country's GDP, about the same as the Japanese government. But in the early 1950s, when Japan had the same level of per-capita income as India does today, Japanese government consumption accounted for only 20-22 percent of GDP. When the US had the same level of per-capita income, in the early 1900s, its government spent just 7 percent of GDP.

Another key to reducing the extent of the informal economy is to streamline regulatory procedures. Registering a new business is often an onerous process. But when businesses fail to register, collecting taxes from them and enforcing regulations is nearly impossible. Tax codes are often overly complicated as well. Spain increased the amount of taxes collected from small and mid-sized businesses by 75 percent after giving small businesses the option of calculating taxes based on physical characteristics, such as a store's square footage, rather than reported revenue, which is difficult to verify.

Governments have the power to reduce informality, and can reap sizable economic gains in the process. The political challenges are considerable. But policymakers must remember that any short-term disruption is far outweighed by the longer-term boost to productivity and economic growth.

Ms. Farrell is director of the McKinsey Global Institute, McKinsey's economics think tank.

Reprinted from The Asian Wall Street Journal © 2004 Dow Jones & Company, Inc. All rights reserved.

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