Tackling the informal economy

By Diana Farrell

Companies that operate in the gray sap economic growth in the developing world, Diana Farrell, director of the McKinsey Global Institute, writes in a new monthly  BusinessWeek column. Here's what governments can do about it.

McKinsey's Diana Farrell says companies operating in the gray zone sap economic growth in the developing world. Here's what governments should do

What do Japan, Singapore, South Korea, and Taiwan have in common? Obviously, they are Asian nations that joined the ranks of the wealthy during the second half of the 20th century. But a less well-known shared feature is that none of them have much of an informal economy.

Research on economic development from the McKinsey Global Institute (MGI) and others shows consistently that these two facts are closely related. Sadly, the converse is also true: When large numbers of businesses fail to register, ignore labor laws, flout regulations, and evade taxes, they hinder the expansion of more productive, modern companies.

Tiny Traders
That puts a powerful brake on a country's growth rate, locking it into a condition of "emerging but never quite making it," and condemning those living and working in the gray economy to a lifetime of insecurity and poor living standards. For Asian nations with large informal economies — the Philippines, Indonesia, Thailand, India, and Vietnam among them — this is bad news indeed.

This view, however, is not accepted by many policymakers and development economists. Two myths prevail. The first is that unlicensed activities by unregistered businesses paying little or no tax do not threaten the growth of the formal, modern economy. Many believe that informal operators are mostly tiny street traders, too small to prosecute for tax evasion, and any that grow bigger will naturally choose to "go straight" as they expand.

The second myth is that for a country experiencing mass rural-urban migration, a growing informal sector is a godsend because it will create jobs much faster than the formal economy can.

Incentive To Hide
Neither of these myths is supported by the evidence. Informal sectors across the world contain a huge range of businesses. Of course, many informal enterprises are small-scale services, especially in retail and construction.

But some are very large operations. In our studies on developing-country economies, MGI has found supermarket chains, software distributors, auto-parts suppliers, consumer-electronics assemblers, even large-scale industrial concerns — especially in labor-intensive manufacturing — operating in the gray economy.

Informal businesses, even large ones, choose to stay that way if there is no change in the factors that generally drive them into informality: high corporate taxes and the bureaucratic burden of operating formally. In developed countries, only about half of total tax revenue is paid by registered businesses (with the rest contributed by individuals). In developing countries, registered companies pony up a far greater share of tax revenues — about 80% — which creates a big incentive to hide in the informal sector.

Tax Amnesties
On top of the tax costs, bureaucracy can be overwhelming. In Brazil, where the informal economy represents a staggering 40% of GDP and half of all urban employment, it takes 152 days to register a company — three times the world average. Red tape abounds in parts of Asia, too. It takes 71 days to register a business in India, compared with six in Singapore, and three years to close an insolvent business in Vietnam.

Given the costs of obeying the law, who wouldn't operate informally if they could get away with it? And in countries with large informal economies, they generally can. There tend to be few tax collectors, who rarely prosecute, and the judicial systems are inefficient.

Many such countries are given to granting tax amnesties to coax businesses into the formal fold. But these just give informal businesses an incentive to wait until the next amnesty, rather than to become regular taxpayers. Turkey had 10 tax amnesties in the 40 years before 2003, but its informal economy didn't get any smaller.

Slow Growth
In any sector where the costs of operating formally are large, having informal competitors is hugely damaging to the prospects of the law-abiding players. Imagine a tax-paying supermarket in Brazil, for instance, where informal retailers operating midsized supermarkets and mini-marts account for 60% of the food retail market.

The supermarket may be many times more productive than its informal rivals, and offer higher quality, but it won't be able to get near them on price because, thanks in part to the informal food processors and wholesalers supplying them, they have an unearned cost advantage of 50%. It will never make sense for the supermarket to invest in expanding, despite its higher productivity.

Now consider this dynamic played out across every sector in the economy where informal and formal players compete. Clearly, informality removes the incentive for businesses to improve their productivity, and that means it holds back GDP growth. And slow growth means fewer new jobs, which drives more people into the informal sector — further limiting growth in a self-reinforcing cycle.

Policymakers in developing countries may feel that slower growth is a price worth paying for the jobs that their informal sectors create. They certainly employ a lot of people — the International Labor Organization estimates that more than 70% of the workforce in the developing world works informally.

But formal companies can create jobs just as well if they are not overburdened with taxes and red tape. Indeed, onerous labor taxes everywhere encourage employers to underreport their payrolls. Even in highly developed Sweden, informal employment is growing, because Sweden has the second-highest labor taxes in the world.

Informality Spreads
The irony is that in countries with big informal economies, high tax rates are often imposed on businesses to fund generous welfare budgets, and labor laws pose strict burdens on employers to protect workers. But only the minority of people employed by registered companies or by the state are eligible for the resulting benefits. The mass of people working in the gray economy never get social-security payments, nor the protection of employment law.

Given its depressing effect on growth and living standards, governments should curb informality. It will never disappear of its own accord, so long as the benefits to remaining informal remain high for entrepreneurs and they suffer no serious consequences. Indeed, far from withering away with the onward march of global competition, informal sectors are growing.

The Russian Federation, and countries in sub-Saharan Africa, Latin America, and Central Asia have the highest levels of informality, often more than 50% of GDP, and their informal sectors have seen the greatest increase since 1990. But informality is also growing fast in the Middle East, North Africa, and South Asia, according to the World Bank. Even in China, where the economy is booming, the large informal sector has slowed growth in services.

It Can Be Done
The recipe for curbing informality is simple: streamline corporate taxes and business regulations, stiffen penalties for breaking the rules, and apply the penalties to all rule-breakers. Tackling the problem sector by sector will remove the risk of sudden increases in unemployment.

Spain's experience in the 1990s shows that it can be done. The government reduced corporate taxes and created a new agency to fight evasion. It also streamlined labor laws and lowered taxes on employment. The result was mass job creation in the formal economy: Unemployment fell by 40% over the next six years. What is more, tax revenues collected from small companies went up by more than 75%, even though corporate tax rates had come down. Governments can use their revenue gain from tackling informality to help prepare workers who lose their jobs for new work in the formal economy.

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

This article originally ran in BusinessWeek.

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