ARE INFORMAL ENTERPRISES A DRAG ON PRODUCTIVITY IN KENYA? Mehnaz Safavian Lead Financial Sector Specialist World Bank Group, Nairobi

1 Characteristics of the Informal Economy La Porta and Shliefer (2014) have established 5 themes that characterise the informal sector: 1.Significant size: accounts for around 30-40% of total economic activity across the world’s poorest countries 2.It has extremely low productivity compared to the formal economy 3.Removing traditional hurdles such as tax, registration costs and regulations does not always bring informal firms into the formal sector, as productivity is often too low 4.The informal economy is largely disconnected from the formal economy 5.As countries grow and develop, the formal economy begins to dominate economic life and the informal economy shrinks

 Why do firms choose to remain informal, and what are the benefits to formalization?  As firms grow in size, do they stay informal?  Do policies to boost formalization work and are they worth the cost to design and implement? Data sourced from -Emerging literature on firm informality -Data collected on formal microenterprises and informal firms as part of the World Bank’s Enterprise Survey initiative for Kenya ( 2 Key Questions

BACKGROUND TO THE KENYAN MARKET Kenya has the highest proportion of informal to total employment in Africa 1 Kenya National Bureau of Statistics estimates that the informal sector represents 82.7% of employment in Kenya as at Almost 700,000 jobs were created by the informal sector in 2014 vs. 106,000 in the formal sector, according to the Kenyan Economic Survey for In Kenya, more than half of informal sector jobs are in trade, restaurants, and hotels. 3 1 Based on the United Nations’ Economic Commission for Africa coverage group

4 Key Constraints Faced by the Informal Sector Recent data collected on informal firms and formal microenterprises in Kenya reveals the following constraints: 1.Access to finance 2.Electricity problems 3.Access to land 4.Corruption 59% 10.3% 9.3%

5 Access to finance remains the biggest constraint Source: Enterprise Surveys The proportion of firms that consider access to finance their top obstacle is significantly lower as firm-size, measured by the number of employees, increases

6 Access to finance remains the biggest constraint Source: Enterprise Surveys Regional differences are pronounced

 As might be expected, firms that consider access to finance as an obstacle for their current operations are far more common among firms that are financially constrained vs. those that are not (76 vs. 39%, respectively).  Larger, older and more productive firms are less likely to be financially constrained than the rest 7 Over 60% of firms are “financially constrained” Source: Enterprise Surveys Percentage of firms that are financially constrained Labor ProductivityFirm AgeRevenues

CURRENT FINANCING TRENDS IN THE INFORMAL SECTOR 8 ABC

 Younger firms more likely to use their own funds  Furniture industry less likely to use their own funds  Central and Mombasa regions more likely to use own funds 9 Use of Internal Funds Key TrendsFirm Age Industry / SectorRegional Variation A

10 Advances and credit from suppliers/customers Labor ProductivityType of Industry Firm DynamismRegional Variation B

11 Use of banks to finance working capital  Use of bank finance for working capital is more common among firms with more educated owners and among the more productive and large firms (see graph below)  Within firms that use bank finance, 63% report better access to finance as a benefit from registering; the corresponding figure for firms that do not use bank finance is significantly higher at 78%. Source: Enterprise Surveys C

OTHER ASPECTS CHARACTERIZING THE INFORMAL SECTOR Labor Productivity Gender Observations Does the Business Environment Matter?

 Informal firms are much less productive than formal firms, with productivity calculated as value added per employee  Wages in informal firms are around one half of those in small formal firms and one third of larger firms  On average, human capital (measured by education) differences are small between formal and informal firms, but differences in human capital of management are significant. There are enormous productivity gaps between firms run by educated vs uneducated managers and entrepreneurs 13 Labor Productivity 1 Labor Productivity of Informal vs. Formal Micro Firms

 For the informal firms surveyed in Kenya, the mean value of labor productivity equals KES 22,481. The median value is KES 13,000.  However, there are differences in labor productivity across firm-size, sectors, education level of the manager and regions, as seen below: 14 Labor Productivity Firm SizeIndustry / Sector Manager Education LevelRegional Variation Monthly sales per worker (KES, '000) 1

 Women-owned firms in Africa tend to underperform those owned by men  This also holds true for Kenya 15 Gender Observations Monthly sales per worker (KES, '000) Female managers are more likely to operate from inside household premises, less likely to have a job or be looking for one in the formal sector than male managers 2 Labor Productivity of Male vs. Female Managers

 Hypothesis: when the business environment is poor, informal and formal firms will be less distinguishable, and conversely, in a higher quality business environment, differences in growth and productivity between formal and informal firms will emerge.  Findings seem to support the hypothesis, based on the same Enterprise Survey data from the World Bank but from Does the Business Environment Matter? Research based on paper by Gelb, Alan and Mengistae, Taye and Ramachandran, Vijaya and Shah, Manju Kedia, To Formalize or Not to Formalize? Comparisons of Microenterprise Data from Southern and East Africa DB 2007DB 2014 Difference Starting a Business Procedures (number) Time (days) Cost (% of income per capita) Dealing with Construction Permits Procedures (number)68+2 Time (days) Cost (% of income per capita) Paying Taxes Payments (number per year)4241 Time (hours per year) Total tax rate (% profit)

 In 2007, informal firms in Kenya exhibited productivity profiles that are indistinguishable from their formal counterparts  In 2013, informal firms in Kenya exhibited productivity profiles that are quite different from their formal counterparts.  This differential effect has been associated with stronger business environments in other research. 17 Does the Business Environment Matter? 2007: Kernel Density Estimate of Value Added Per Worker in Kenya 2013: Kernel Density Estimate of Value Added Per Worker in Kenya Informal microenterprises Formal microenterprises Formal small enterprises 3

WHO IS GROWING AND WHO IS FORMALIZING? Which sectors are growing and why? What discourages firms from formalizing? What are the perceived benefits from registration? Business registration policies matter

 Expansion defined as an increase in the number of employees, machines, or space used over the last 3 years  About 27% of the informal firms surveyed have “expanded” by this definition over the last 3 years 19 Which sectors are growing? Differences in Firm Age (Median = 4 Yrs)Differences in Manager Education Differences in Type of IndustryRegional Variation 1

20 Factors Discouraging Willingness to Register  Higher labor productivity is associated with a higher proportion of firms reporting each of the above as reasons, with the exception of paying taxes, for not registering  Considered individually, these reasons for not registering show significant variation across regions and the education level of the manager, as seen below: Reason for nit registering (% of firms) 2

21 Perceived Benefits from Registration  Perceived benefits from registration vary by region and firm’s perceived severity of the obstacles  Controlling for region specific differences (region fixed effects), firms that are larger in terms of monthly sales and have higher labor productivity are significantly more likely to report each of the below factors as a benefit from registering. 3

22 Business Registration Policies Matter The discussion above on whether or not firms would like to be registered as well as the obstacles to registering are based on firm’s perceptions.  However, perceptions may not always reflect the underlying objective reality of the costs and benefits of registering  Fortunately, for the case of Kenya, the World Bank’s Doing Business project provides information on select business environment measures for Mombasa, Nairobi and Nakuru regions.  We find some evidence that at least to some extent, firm’s perceptions reflect objective reality. 4

THANK YOU 23 Mehnaz Safavian