WHAT IS THE COST OF FORMALITY: EXPERIMENTALLY ESTIMATING THE DEMAND FOR FORMALIZATION David McKenzie, World Bank (With Suresh de Mel and Chris Woodruff) March 2011

Why are so many firms informal? Exclusion or romantic view  if not for constraints, informal firms would be much larger  Implication -> Doing Business –remove the burdensome constraints and these firms will want to formalize. Exit, parasitic or dual economy views: ◦ Firms deliberately stay informal as see no benefits to formalizing ◦ Implication: regulatory reform may have little effect on getting informals to formalize – only enforcement might do that.

What do we do? Giving difficulty of randomizing roll-out of costs of registration, we focus on the benefits Take a sample of informal firms in Sri Lanka and randomize into 4 treatment groups and a control group: ◦ Treatment groups get information about registration, and then various levels of monetary incentives for registering. We use this to map out a demand curve for formality, to answer the question as to whether existing informal firms want to formalize. Follow-up survey months after formalization then used to measure whether and how formalizing benefits these firms.

Formality in Sri Lanka? Source: SLLSE

Structure of intervention Focus on the DS registration. Why? ◦ Most closely associated with tax payments ◦ BRC needed for formal bank loans, issuance of official receipts. Perceived costs of registering?  Taxes (46%) ; time consuming (37%); subject to ETF/EPF (24%) Perceived benefits?  Bank account (56%); none (23%) Did not know cost of registering, tax laws

Treatments ◦ Treatment 1: Information on costs and benefits of being registered (prepared with DS, Chamber of Commerce), plus reimbursement of direct registration costs (modest) ◦ Treatment 2: Information plus payment of 10,000 Rs (~$85, or 40% of median monthly reported profit) ◦ Treatment 3: Information plus 20,000 Rs payment ◦ Treatment 4: Information plus 40,000 Rs payment  Treatment 4a: 80,000 Rs.

Information Brochure Content Could Business Registration Lead to the Success of Your Enterprise? ◦ What is meant by business registration? ◦ Why should an enterprise be registered? What are its benefits? ◦ Then why do many entrepreneurs not register their business? ◦ Where should you go in order to register your enterprise? ◦ What are the requirements for business registration? ◦ What is the process of business registration? ◦ What is the cost of Business Registration? ◦ How long does it take to obtain the business registration certificate? Business name registration is an important decision for the future development and growth of your enterprise. Consider its costs and benefits and make your decision.

Who is more likely to register? More likely to register if: ◦ In Colombo (where process is easier) ◦ Not operating on public or temple land (where it is difficult to register) ◦ If business has more assets, and has visible sign ◦ If don’t expect to have more than 15 employees

What are the consequences of formalizing? Carried out a follow-up survey in August 2010 ◦ Timing is months after registration Were able to re-interview 465/520 original firms (89%) ◦ Can’t reject attrition unrelated to treatment at conventional significance levels

Open-ended direct questions to firms on what formalization has done for them:

Impacts on Firm outcomes

Are any of the channels operating?

Impacts on attitudes

Conclusions More support for exit than for exclusion ◦ No evidence that up-front costs / information are key constraints Relatively modest payment results in half of firms registering ◦ Suggests a modest wedge in costs from registration. (Wedge may be larger if discount rates are high) Importance of land issues: even firms operating on government land were not able to register! While we lack power to obtain precise estimates on ultimate firm outcomes, we don’t find any significant impacts on profitability or firm size, or benefits like increased access to credit, obtaining government contracts, or participating in government programs. => Firms seem therefore to be rationally refraining from formalizing unless paid to do so.

Policy implications Results suggest little in the way of pent-up demand for formalization among existing formal firms ◦ If want to formalize existing firms, need larger changes in cost-benefit analysis – more benefits from formalizing and/or more enforcement. Benefits of reform may instead mainly be at extensive margin – in drawing in different types of entrepreneurs if it is easier to start a business.