Commentary: Boost Growth By Reducing the Informal Economy.
World financial leaders gathered recently in Washington for the annual meetings of the World Bank and International Monetary Fund. But missing from their agenda was one of the biggest and most misunderstood barriers to economic growth: the vast agglomeration of businesses that evade taxes and ignore regulations, often referred to as the "informal economy,” writes Diana Farrell, director of the McKinsey Global Institute, in Monday’s edition of The Asian Wall Street Journal.
The informal economy is not just the unregistered street vendors and tiny businesses that form the backbone of marketplaces in Asia and other emerging markets. It includes many established companies, often employing hundreds of people, in industries as diverse as retail, construction, consumer electronics, software, pharmaceuticals and even steel production. In India, Pakistan, Indonesia and the Philippines, as much as 70 percent of the non-agricultural workforce is employed in informal businesses.
Despite the prevalence of the informal economy, Asian policymakers show surprisingly little concern. Some governments argue that it helps relieve urban employment tensions and will recede naturally as the formal economy develops. Development experts contend that informal companies themselves will grow, modernize, and become law-abiding if given some help. And most policymakers implicitly assume that the informal economy does no harm. But there is little evidence to support these beliefs. Research by the McKinsey Global Institute found that informal economies are not only growing larger in many developing countries, but are also undermining enterprise-level productivity and hindering economic development.
The reasons why informal economies grow -- and keep growing -- are not hard to uncover: high corporate tax rates and the enormous cost of doing business legally. It takes 89 days to register a business in India, compared with eight days in Singapore. It takes 33 days to register a property in the Philippines, compared with 12 in the US. It takes five and a half years to close an insolvent business in Vietnam. All in all, emerging-market businesses face administrative costs three times as high as their counterparts in developed economies. No wonder so many choose to operate in the gray.
Reducing the tax burden on businesses is perhaps the most critical step to reducing informality, since high taxes increase the incentives for companies to operate informally. For many Asian governments, one path to lower taxes is through broadening the tax net: collecting taxes from more companies can enable governments to cut tax rates without reducing tax revenue, while simultaneously breaking the tax-evasion cycle. Another key to reducing the extent of the informal economy is to streamline regulatory procedures. Registering a new business is often an onerous process, Farrell writes.
The informal economy is not just the unregistered street vendors and tiny businesses that form the backbone of marketplaces in Asia and other emerging markets. It includes many established companies, often employing hundreds of people, in industries as diverse as retail, construction, consumer electronics, software, pharmaceuticals and even steel production. In India, Pakistan, Indonesia and the Philippines, as much as 70 percent of the non-agricultural workforce is employed in informal businesses.
Despite the prevalence of the informal economy, Asian policymakers show surprisingly little concern. Some governments argue that it helps relieve urban employment tensions and will recede naturally as the formal economy develops. Development experts contend that informal companies themselves will grow, modernize, and become law-abiding if given some help. And most policymakers implicitly assume that the informal economy does no harm. But there is little evidence to support these beliefs. Research by the McKinsey Global Institute found that informal economies are not only growing larger in many developing countries, but are also undermining enterprise-level productivity and hindering economic development.
The reasons why informal economies grow -- and keep growing -- are not hard to uncover: high corporate tax rates and the enormous cost of doing business legally. It takes 89 days to register a business in India, compared with eight days in Singapore. It takes 33 days to register a property in the Philippines, compared with 12 in the US. It takes five and a half years to close an insolvent business in Vietnam. All in all, emerging-market businesses face administrative costs three times as high as their counterparts in developed economies. No wonder so many choose to operate in the gray.
Reducing the tax burden on businesses is perhaps the most critical step to reducing informality, since high taxes increase the incentives for companies to operate informally. For many Asian governments, one path to lower taxes is through broadening the tax net: collecting taxes from more companies can enable governments to cut tax rates without reducing tax revenue, while simultaneously breaking the tax-evasion cycle. Another key to reducing the extent of the informal economy is to streamline regulatory procedures. Registering a new business is often an onerous process, Farrell writes.
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