To Formalize or not to Formalize?

TO FORMALIZE OR NOT TO FORMALIZE?

Thinking in terms of strict dichotomies makes things easier. However, such artificial dichotomies rarely stand up to evidence. In business studies, categorizing the entrepreneurial world into formal and informal sectors had been the practice for many years. As expected, this neat dichotomy breaks down in the face of data. Colin C. Williams and M. Shehryar Shahid, in their research article published in Entrepreneurship & Regional Development: An International Journal (2014), have done exactly that. In the process Williams and Shahid have also been able to provide an answer to the question: why do entrepreneurs prefer to operate in the informal sector? Their answer has far-reaching implications for policy-makers in Pakistan.

To begin with, Williams and Shahid reject the strict dichotomy between the formal sector (characterized by codified laws) and the informal sector (characterized by norms and values). They argue that the following classification is a more accurate one in light of the evidence that they have collected: wholly informal, largely informal, largely formal, and wholly formal. After interviewing 300 entrepreneurs in Lahore, the authors found that 62% (almost two-thirds) of them worked wholly informally. This meant that they were neither registered as a limited liability company, nor did they keep their accounts in compliance with the Companies Ordinance 1984; they were not registered with the government under the Income Tax Ordinance 2001 either.

Interestingly, the other 38% (more than one-third) of the entrepreneurs worked either largely informally or largely formally. Conversely, and equally importantly, this meant that 0% (none) of the entrepreneurs interviewed during the research worked in the wholly formal sector. These data confirm what has been dubbed as a major impediment in Pakistan’s development: despicably low tax revenues.
As to why entrepreneurs prefer to operate in varying degrees of informality, Williams and Shahid advance the existing explanation that claims that the more difficult it is to formalize and abide by all the rules and regulations of the government, the greater the number of entrepreneurs who decide to operate informally.

Going beyond the conventional explanation, however, the authors have identified the key characteristics of entrepreneurs that determine the degree of formality or informality with which they operate. The authors tell us that entrepreneurs who are young, who are less educated, and who earn less tend to operate wholly informally. As these factors increase, so do the odds of them attempting to formalize.
Furthermore, the entrepreneurs who prefer to work informally perceive their chances of getting caught as low and they also have little motivation to pay their taxes. Conversely, the entrepreneurs who operate completely formally perceive their chances of getting caught as high and have greater motivation to pay their taxes. What is interesting, though, is the fact that almost all entrepreneurs perceive the public sector as corrupt.
For government policy-makers who are serious about bringing more business and people into the tax net, these findings by Williams and Shahid provide a roadmap for the future. By investing in the education sector and intellectually empowering the entrepreneurs of tomorrow, the government can ensure greater income for them. This will in turn encourage them to formalize. Similarly, by countering public sector corruption—as well as challenging the perception of it—the government can ensure that more entrepreneurs would want to come into the formal fold. Lastly, by eliminating tax unfairness and the perception that the tax collected by the government is ill-spent and does not benefit an overwhelming majority of the country, the government can ensure greater tax collection as it will encourage more entrepreneurs to register with the government and pay their dues.

Reference: Williams, C.C., & Shahid, M. S. (2014). Informal entrepreneurship and institutional theory: explaining the varying degrees of (in)formalization of entrepreneurs in Pakistan. Entrepreneurship & Regional Development: An International Journal, 28(1-2), 1–25.
http://dx.doi.org/10.1080/08985626.2014.963889