MSMEs: Gradual transition from informal to formal for MSMEs

There is a large body of work highlighting the importance of formalization and the persistence of informality in the economy. Representing a major feature of labor markets around the world, the informal sector consists of activities operating outside the regulatory framework that would potentially add value to tax revenues and GDP but are not accounted for. A recent estimate suggests that the informal sector still accounts for around a third of economic activity in low- and middle-income countries. The statistic is more glaring for micro, small and medium-sized enterprises – the informal economy comprises more than 90% of micro and small enterprises in the world. It is well known that India is no exception to the prevalence of informality. In India, 99.7 percent of businesses belong to the unorganized sector, two-thirds of which are not registered anywhere. A significant fraction of these unorganized enterprises fall into the “micro” category of the MSME sector comprising owner-managed enterprises, most of which operate with less than five workers. After years of talking about increasing formalization in the sector, it is time we truly understood that going formal is a protracted process. It will take an integrated, economy-wide approach that assesses the challenges businesses face at every stage of their trajectory – from reasons for not being registered to problems encountered after formal registration.

Understanding why companies choose to operate informally is a starting point.

It is essential to consider formalization from the perspective of an informal enterprise. Formalization entails certain costs as well as benefits for undertaking economic activities. While the regulatory apparatus is complex and imposes significant costs, it is a key deterrent for businesses to register. This is especially true for small businesses with narrow profit margins who find compliance costs financially burdensome. Likewise, strict and complex labor laws are also one of the reasons why businesses remain small and unregistered. It is essential that small businesses are aware of the benefits of formalization. Benefits may include access to various government grants and incentives, enforceable business contracts, tax breaks, access to formal credit channels, and other incentives. With greater access to these resources, it is easier to increase productivity through technological improvements in production and digitization. However, if the regulatory ecosystem incentivizes staying small without providing adequate benefits to scaling and formalization, the lure of informality will prevail. As Dagmar Walter, Director of the ILO’s Decent Work Technical Support Team for South Asia, explains, “When the benefits of formality outweigh the costs, informality rates are likely to decrease. However, although a cost-benefit perspective helps policy makers get an idea of ​​the persisting informality among micro-enterprises, it is still a limited approach. It must be complemented by a holistic development strategy creating pathways to formalization. The point to make here is that the reasons for staying small and informal are not always tied to tax considerations and other legal compliance costs. Low productivity and a lack of competitiveness can hamper the transition from informal to formal for many micro-enterprises, as they may not have the ability to outlast competitors in the formal sector. If small businesses owe their survival to informality, it is obvious that they will see an interest in remaining informal. Thus, a holistic development strategy that allows micro-enterprises to thrive in the formal space is essential. Boosting investment in human capital through education, skills and health will not only improve the competitiveness of the entrepreneur, but also that of the pool of talent available for employment in the sector.

Given the various reasons why businesses are not registered, tackling informality requires a multi-pronged approach. This is not an overnight change, but a gradual change by creating the right environment for companies to be attracted towards formalization. Stepping outside the formal scope makes it difficult for schemes and programs to reach them. Simply put, in order to be able to target reforms, we need to be aware of the existence of potential beneficiaries. The multitude of initiatives put forward by the government may not be able to reach these unregistered businesses, which still keeps them at low capacity.

Reforms should not stop at the successful registration of an economic unit. We must strive to create pathways for registered units to thrive and achieve higher levels of productivity. Considering the number of non-agricultural unincorporated enterprises, assessing the drivers and causes of informality for each sector and geographic level is the need of the hour. There are many micro-enterprises with untapped potential. With the right incentives to formalize and reforms to help them grow, we can unlock their potential to drive economic growth and pave the way for the goal of decent work for all.

Amit Kapoor is President of the Institute for Competitiveness, India; Visiting Scholar and Lecturer, Stanford University. Shivani Kowadkar is a researcher, Institute for Competitiveness, India.