What is the cost of Formality? Experimentally estimating the demand for formalization, S del Mar, D. McKenzie & C. Woodruff (Journal of Economic Literature)

In a Nutshell

One of the major constraints on the ability of developing nations to raise tax revenues is the large component of the economy that is informal and hence outside of the tax system. There are two broad theories as to why firms are informal. Firstly that associated with De Soto claim that firms are informal because of over burdensome entry regulations to being formal. The Second argues that entrepreneurs weight the costs (registration costs, taxation costs) and benefits (access to banks, courts, other public goods) of formality and make a rational choice. This implies that as firms grow, they will be more likely to benefit from formal institutions and hence they will be more likely to become formal. The question is important as from the perspective of the government; they want to encourage formality in order to increase tax receipts, and so understanding what encourages formality is key.

In order to provide evidence for the debate the authors conduct an RCT in Sri Lanka, whereby one group of firms was given information about the benefits of formality and an offer of a refund of the registration fee. Then three other groups were given the same information, and then a progressively large reward for registration within one month. 

They found no effect of the information only treatment relative to the control, and progressively more firms registering as the reward increased. By comparing firms in two regions where registration differs by ease (in terms of time) and cost, they are able to state that there was more formalization where the process was easy, but that the difference in costs played no part. In the absence of a monetary incentive to formalize, firms chose to remain informal. This is most consistent with the rational choice model of informality rather than the De Soto view. Additional evidence for this is that larger firms (for whom formality would be the most expensive) were also much less likely to have formalized at all experimental incentive levels. The fact that more firms formalize when the reward increases indicates that some financial gain is needed in order to offset the cost of being formal.

Whilst this is not an experiment that naturally lends itself to policy recommendations it can be said that in order to increase informality the following steps might be taken:

  • Reduce the time burden of registering, and streamline the process
  • Reduce the costs of formality – as the article below makes clear, corporation tax is high in the developing world, making formality disproportionately expensive.
  • Improve land rights – in the follow up study the researchers asked why certain firms had not registered even though they wanted to, and it was stated that they did not have land rights to their place of business (as it was on public/church land etc.), and this meant that they were unable to register the business.



Tax Structures in Developing Countries: Many puzzles and a possible explanation, R. Gordon & W. Li (Journal of Public Economics)

In a Nutshell

Tax structures in the developing world are systematically different to those in the developed world. They collect less overall revenue, less income tax, they rely more on corporation tax as well as consumption and production taxes. They also have higher tariff levels and inflation is higher (tax on savings). In other words they tend to have higher tax levels in the most distortionary of taxable areas.

There are several plausible reasons for this:

  • People in developing countries do not value public goods in the same way as in the developed world and so taxes are of lesser importance – this hardly seems likely given the public infrastructure needs in these regions.
  • They have different public attitudes to redistribution – this is possible although unlikely (and uninteresting)
  • They face constraints on their ability to collect taxes effectively – this is the best candidate.

The mechanism theorized in this paper is that they face constraints due to the large informal economy. The government relies on access to bank information in order to correctly tax activity. Firms are thus only subject to taxes when they choose to make use of the financial sector. When taxes are high enough, many firms will opt for informality. This mechanism has little effect in the developed world where the benefits from using the financial system are high, but may of great importance in the developing world where underdeveloped financial systems give little benefit to the entrepreneur, and hence provide no balance to the income that will be lost through the subsequent taxation that occurs pursuant to use of the financial system.

This explains why there are differential VAT rates on firms that find it difficult to be informal (as they have greater tolerance of tax), why tariffs are often used (as they can be easily identified whereas VAT payments on the finished product are easily obscurable), and why consumption taxes are high.

The key take away is that it is important to understand why tax systems are so different in the developing world, before making concrete recommendations about how to reform them.


Income Inequality and Progressive Income Taxation in China and India, 1986-2015, T. Piketty and N. Qian (American Economic Journal 2009)

In a Nutshell

Income taxation can increase revenues and are less distortionary and regressive than taxes on consumption and production. In China, whilst virtually no one was subject to income tax due to high exemption level, as income per capita has risen, the exemption levels have remained fairly constant, which has meant that many more people have been subjected to income tax as the nation’s wealth grows. This has seen an increase in taxable population from 0.1% to around 20% and this has meant that income tax now accounts for around 2.5% GDP.

The situation in India is very different. Due to the frequent updating of the exemption rates, the taxable population has stagnated around the 2-3% level, and income tax represents a tiny 0.5%GDP.  However, one driver of this may be that the proportion of formal wage earners in India is very low (so not moving the exemption rates would mean increasing penalization of a relatively small group of formal wage earners).

Moving from an elite income tax rate to a more broad based and progressive system is exactly the type of fiscal modernization process followed by Western countries in the early 20th century. This implies that developmental assistance could be directed at improving fiscal systems.

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