Governments and donor agencies around the world are doing a lot to strengthen the formal economy – but not all their efforts are successful | D+C

In developing and emerging economies, governments are struggling to move businesses from the informal to the formal sector. In this context, donor agencies can have both positive and negative influence. This is evident in sub-Saharan Africa for example.

The informal economy does not have a good reputation in western industrialized countries like Germany. A fundamental reason is that it operates outside the realm of tax and welfare systems. Many critics see it as an underground economy, with actors illegally circumventing the payment of taxes and social security contributions. On the other hand, many informal workers view government institutions and state structures with scepticism.

In most low-income countries, state structures tend to be young and often date back to authoritarian colonial rule. They are widely seen as artificial – contrary to long-established socio-cultural traditions and norms. According to the World Bank, the informal sector in emerging markets and developing economies accounts for about a third of gross domestic product (GDP) and about 70% of employment (World Bank 2021). Many of those affected are self-employed.

One would intuitively expect informal employment to move counter-cyclically towards formal employment. When the formal economy weakens, after all, people lose their jobs and are forced to earn money informally. In times of economic recovery, however, there are new opportunities to move from the informal to the formal sector.

In reality, however, things are more complex. For example, the informal sector can provide additional growth impulses during an economic recovery. However, the potential differs from country to country. Among other things, the dynamic depends on:

  • how flexible and how formally regulated markets are
  • what levels of demand for informal labor predominate.

Strikingly, according to the International Monetary Fund (IMF), informal businesses and workers have been particularly hard hit by the economic downturns caused by the Covid-19 pandemic.

Exploitation and meager remuneration

Many workers in the informal sector endure poor working conditions. In some cases, they are severely exploited and can even live in conditions close to slavery (see Markus Loewe on www.dandc.eu on the question of social security). The wage gap between the formal and informal sectors is considerable. One of the main reasons for the different pay levels is that the productivity of formal firms can be up to twice as high as that of informal firms. This is largely due to higher levels of education, and this applies to the workforce as well as management.

In sub-Saharan Africa, the informal economy is more pronounced than in any other region of the world, accounting for around 34% of economic output (IMF 2020) (see Karim Okanla at www.dandc.eu on the informal sector in Benin). Even people in formal employment are often involved in some informal activity, either personally or through family members. In Latin America and South Asia, the informal economy also accounts for a significant share of GDP. However, it has decreased in all regions mentioned here.

South of the Sahara, most micro, small and medium-sized enterprises (MSMEs) are not officially registered; most of their workers have no employment contract – let alone a job description. Many are paid late or irregularly. The tasks they perform depend largely on their relationship with the owner-manager, who will often be a relative.

Companies that often fail

Some informal entrepreneurs are quite successful, but most businesses don’t last long. Statistics tend to be of dubious quality, as informal businesses also lack an official paper trail. Nevertheless, it is safe to say that most MSMEs in sub-Saharan Africa do not survive five years.

Many African governments want to formalize informal businesses. Reasons include that they wish to:

  • support companies more effectively in their quest for growth and jobs,
  • benefit from more tax revenue and
  • make production more environmentally and socially sustainable.

To achieve this, governments cooperate with donor agencies. In joint efforts, they support businesses with capital grants, loans, and job training. KfW Development Bank and the European Investment Bank expect each financial institution to support it in implementing an Environmental and Social Management System (ESMS). The idea is to channel financing to borrowers who respect environmental and social standards.

Professional training provided by donor institutions generally covers various areas of management, including business and investment planning, financial management, human resource management, and sales and marketing. Skills in these areas help a business grow. Gaps in relevant skills often stall businesses.

Additionally, formal business skills are often a prerequisite for obtaining loans. Formalized financial institutions, after all, are accountable to regulators, so they need a clear understanding of where their debtors are – and only those customers’ financial reports can provide that kind of insight.

Better business education is needed

According to a review of the literature on the effectiveness of training efforts focused on improving business skills (McKenzie and Woodruff 2014), the impact tends to be rather limited. One of the reasons is that the participants are too heterogeneous. In practice, efforts to formalize businesses often boil down to the issuance of registration certificates. Some financial institutions also seem quite happy to refuse loans on the pretext that a company has no formal status, for example because they prefer to invest risk-free in government bonds.

The larger a country’s informal economy, the lower its tax-to-GDP ratio. Many African governments have reformed their tax laws to address this problem. Nevertheless, many of them are still reluctant to rigorously apply fair taxation. Part of the problem is that these governments have an easier time getting donor funding than collecting taxes.

Despite all the criticism, lenders often play a positive role in enabling companies to obtain suitable loans. For example, they can encourage financial institutions to accept movable assets as collateral. In addition, they help financial institutions to expand their range of services, which is particularly useful with regard to financial products that have proven useful for the promotion of MSMEs elsewhere. On the other hand, donor agencies also tend to pressure financial institutions to provide loans even when they are unwilling or strategically positioned to do so.

Ultimately, what is needed to improve the interaction of the informal and formal sectors is sound macroeconomic policy. It should prioritize creating incentives for private sector investment – ​​particularly in capital goods, vocational training and business formalization. Donor organizations need to constantly reassess their role in this context and, if necessary, adjust their policies.


Sources

IMF, 2020: What is the informal economy?

https://www.imf.org/Publications/fandd/issues/2020/12/what-is-the-informal-economy-basics

World Bank, 2021: The long shadow of informality – challenges and policies. Edited by Ohnsorge, F., and Yu, S., Washington, DC.

https://www.worldbank.org/en/research/publication/informal-economy

McKenzie, D., Woodruff, C., 2014: What are we learning from business training and entrepreneurship assessments in the developing world? The World Bank Research Observer, vol. 29, no. 1.


Oliver Schmidt is senior project manager at the consultancy AFC (Agriculture and Finance Consultants) based in Bonn. AFC is the competence center for financial sector development of the GOPA Consulting Group, which provides advice to international development agencies.

[email protected]

About Mitchel McMillan

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