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  • Nadia Lee

The Formalization Formula and What It Got Wrong


In the United States, the informal market includes activities as trivial as babysitting your kid neighbor and as lucrative as smuggling drugs. But, informal markets take a more sizable chunk of developing economies. There, the informal market includes career jobs in between- running a clothing business or doing temporary, contracted labor such as making a website.  Recent studies in Sub-Saharan Africa suggest the informal market generates up to 65% of economic activities among countries in this region

The informal market sees less success in the US because maintaining a sustainable, informal local business in the United States is difficult. Widespread reliance on credit cards and banking infrastructure, institutions that report transactions, would make it difficult for a hypothetical informal business to grow its consumer base while staying under the radar. In addition, active tax fraud investigation and interactions with other, mostly formal, businesses act as deterrents to long-term informality. In many developing countries, however, informal businesses make up their own self-sufficient market- allowing members to bypass these deterrents. 

Formalization research in developing countries focuses on getting informal jobs onto government records. Formalization builds the tax base which paves the way for infrastructure projects and government welfare programs. Researchers also believe formalization would help the African housing crisis because it improves informal workers’ access to loans, particularly mortgages. Without government records, many bankers are hesitant to lend. But, recent papers are also considering whether or not countries should formalize at all. 

The most pressing objection to formalization is that it doesn’t work. The prevailing policy promotes a “nudge” approach, focused on financial incentives and easing registration requirements to avoid capsizing any businesses too small to handle taxes and regulation. In practice, however, this approach could not motivate informal workers and business owners to make the change.  

An overview of studies about formalization in developing countries found that these “nudge” policies failed to increase the number of firms formalized. Individual studies reveal different possible explanations for the policies’ lack of effect. In a study of Peruvian small businesses, for example, researchers found that businesses would formalize and then claim to be defunct when the burden of taxes and regulation was too much. 

A different study in Indonesia revealed a complete lack of interest among small business owners. In interviews both formal and informal business owners expressed distaste for paying taxes, citing concerns about corruption and mediocre government service. However, many small business owners expressed contentment with serving their specific local communities and felt formalizing was only necessary for expanding one’s business. Similarly, formalized small-scale business owners claimed accessing loans or government subsidies was the primary reason for registering their businesses. 

These different explanations point to another obstacle in formalization policy: the possibility that all models can be true at once. In a report focused on women in the informal workforce, researchers found a tier system within the informal sector. The best off were primarily entrepreneurs with their own businesses, then independent, temporary workers (gig workers), and finally outworkers who were informally employed by export companies (think fast fashion or Coca-Cola) to do underpaid, unregulated work. 

The same report found that for entrepreneurs and gig-style workers, moving in and out of the formal sector was a matter of cost-benefit analysis and identifying business registration avenues, much like the Peruvian micro enterprises.  For the outworkers, however, their country’s gradual development is their best bet. Tighter regulation and better job opportunities - both of which tend to occur as a country develops - have historically been the solution to the outworkers’ plight.

Research beyond “nudge” policy case studies depicts a hefty burden for governments interested in tapping into the informal sector’s tax potential. On top of cutting red tape and educating business owners about the registration process, governments must think about the financial incentives it can bring to currently informal workers and businesses. A brief report on informal work in the United States suggests that extensive tax credits, tax-based welfare services, and worker protections encourage individual American workers to prefer formal employment. Getting businesses on board is more complicated. 

Businesses must be motivated to expand through already formal systems like international or national banking systems. At the same time, however, credit systems must be willing to lend to businesses at reasonable rates. Governments must be able to provide reliable protections to businesses once they have expanded, like intellectual property rights, legal protection in transactions, and financial support in times of crisis. In order to provide these protections, however, governments need more resources, and the formalization problem goes back to where it started.

There is no magic bullet for formalization, the process is as complex and as simple as economic development itself. 


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