The Demand for, and Consequences of, Formalization among Informal Firms in Sri Lanka

The majority of firms in most developing countries are informal. The authors of this paper conducted a field experiment in Sri Lanka that provided incentives for informal firms to formalize. Offering only information about the registration process and reimbursement for direct registration costs had no impact on formalization. Adding payments equivalent to one-half to one month's profits for the median firm led to registration of around one-fifth of firms. A larger payment equivalent to two months' median profits induced half the firms to register. The main reasons for not formalizing when offered incentives included issues related to ownership of land and concerns about facing labor taxes in the future. The degree of bureaucracy in the registration process also seems to matter for those with the incentive to register, with response to the incentives higher in Colombo, where the registration process was easier, than in Kandy. Three follow-up surveys, at 15 to 31 months after the intervention, measure the impact of formalizing on these firms. Although mean profits increased, this appears largely due to the experiences of a few firms that grew rapidly, with most firms experiencing no increase in income as a result of formalizing. The authors also find little evidence for most of the channels through which formalization is hypothesized to benefit firms, although formalized firms do advertise more and are more likely to use receipt books. In qualitative interviews owners of formalized firms also feel their businesses have more legitimacy. Finally, formalizing is found to result in a large increase in trust in the state. Their focus is largely on the private costs and benefits of existing firms formalizing. Within their sample they cannot measure broader impacts of formalization on other firms (who may prosper from not having to compete against informal firms not paying taxes), nor impacts of easier formalization on entry of new firms. Nevertheless, our results suggest that although most informal firms do not want to formalize, given the current private costs and benefits of formalizing, policy efforts that lead to relatively modest increases in the net benefits of formalizing would induce a sizeable share of informal firms to formalize.