Registering for Growth: Tax and the Informal Sector in Developing Countries

Christopher Woodruff

Roughly half of all non-agricultural workers in developing countries work in very small enterprises with fewer than five employees. Indeed, between one-quarter and one-third of the non-agricultural workforce in most low- and lower-middle-income countries is self-employed (Gollin 2002).

Most of these micro-enterprises operate without registering as legal entities and, as a result, are a part of what is commonly referred to as the informal sector. Informal activity is estimated to comprise a much larger share of the economies of low-income countries – on average around 42% of GDP in a sample of 31 lowand lower-middle-income countries – than a comparable sample of 32 higher-income countries (22% of GDP) in the Organisation for Economic Co-operation and Development (OECD).

Why is such a high proportion of the labour force in lower-income countries employed in the informal sector? De Soto (1989) famously proposed that governments- and Peru’s specifically – push firms into the informal sector by raising the barriers and costs of formalization. By excluding firms from the formal sector, these barriers stifle entrepreneurship and reduce the dynamism of the private sector. Others (Levy 2008) have claimed that the high levels of informality represent an escape by small firms. This ‘exit’ view leads to a vicious cycle: firms escape because the state does not make formal status appealing. For example, financial markets and courts may be dysfunctional, and public procurement processes may be corrupt. But by being in the informal sector, firms avoid paying taxes that would provide resources the state might use to improve the provision of these goods, or to force firms to become formal. In this view, informality may still stifle entrepreneurship, as firms sometimes remain small deliberately to avoid attracting the attention of regulators and tax collectors.

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