Race to the Next Income Frontier
Chapter

Chapter 16. Improving the Contribution of the Informal Economy to GDP Growth

Author(s):
Ali Mansoor, Salifou Issoufou, and Daouda Sembene
Published Date:
April 2018
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Author(s)
Ahmadou Aly Mbaye and Nancy Benjamin

Introduction

In Senegal, as in most African countries, the informal sector is large and employs an important segment of the population; therefore, improving its contribution to the economy is essential to growth. The informal sector produces more than half of the country’s total economic output and accounts for three-quarters of total employment. In particular, it provides a major source of employment for youth and women, since entry is generally easier than in the formal labor market, while the incomes are always lower. It also absorbs the majority of workers leaving agriculture for the urban economy. Finally, almost all small enterprises in Senegal are informal. Thus, the informal sector provides an important contribution not only to total economic growth, but also to inclusive growth.

Efforts to improve the contribution of resources employed in the informal economy first require an understanding of why those resources end up in the informal sector to start with. In Senegal, specific aspects of the business climate contribute to a dual regulatory regime: few firms (mostly multinationals) qualify as completely formal, and most firms engage in behavior that is informal in some important respects. Among the more sophisticated and higher-value-added informal firms, for example, almost all are registered somewhere or are otherwise known to the authorities, and almost all pay some kind of taxes. However, these same firms are unlikely to keep accurate accounts, to report all of their workers or all of their income, or to pay the regulated amount of tax. For small informal firms, the same is true, but even less of their activity functions in a formal fashion.

Table 16.1 and Figure 16.1 show the share of informal activities in various sectors of the economy in Benin, Burkina Faso, and Senegal (Benjamin and Mbaye 2012a). It is clear from the data that almost all the value added in the primary sector is informal, as is the case in the service sector. Furthermore, throughout the economy as a whole, at least half the value added is informal. As for employment in West Africa, 73.3 percent of employment on average is in the informal sector (Table 16.2).

Figure 16.1.Informal Sector’s Share of GDP for Primary, Secondary, and Tertiary Sectors

TABLE 16.1Share of Total Value Added of Formal and Informal Sectors, 2003 and 2004
BeninBurkina FasoSenegal
2003Share (percent)2004Share (percent)2003Share (percent)2004Share (percent)2003Share (percent)2004Share (percent)
Total Value Added1,900.601001,961.701002,583.141002,713.931003,500.621003,715.01100
Formal Sector510.2026.84519.2026.471,308.750.661,379.7050.841,578.5745.091,730.8146.59
Informal Sector1,390.4073.161,442.5073.531,274.449.341,334.2049.161,922.0554.911,984.1953.41
TABLE 16.2Average Employment in the Informal Economy as a Share of Nonagricultural Employment, Selected World Regions and West and Central African Countries, 2000–10(Percent)
Region/CountryAverage Employment
North Africa53.0
Sub-Saharan Africa70.5
West Africa73.6
Benin96.3
Burkina Faso90.5
Guinea86.7
Senegal76.0
Central Africa85.4
Cameroon84.0
East Africa65.3
Southern Africa62.3
Latin America57.7
South and Southeast Asia69.7

It is our view that the cumbersome business climate contributes significantly to the predominance of the informal sector in Senegal, given that it is close to impossible to do business while operating openly and transparently.

Informality and the Business Climate in Senegal

The current business climate and cost structure in Senegal impose the following choice: either cultivate rent capture or operate informally. Neither choice promotes raising productivity.

The constraints related to the investment climate are generally perceived as encouraging informal activity. Increasingly, the economics literature views informal sector status as the result of a cost-benefit calculation on the part of the agents (Johnson and others 2000; Galal 2005; Djankov and others 2002). A hostile environment can push an agent into the informal sector, but the agent’s characteristics will also affect the decision.

Impact of Excessive Regulations

Loayza (1997) views excessive taxes and regulations as the main factors explaining which sectors are dominated by informality. Moreover, according to Nipon (1991), businesses within the informal sector pay their workers 13 to 22 percent less in wages, as a result of evasion of labor market regulations. In his empirical model for Latin America, Loayza (1997) finds that tax burdens and labor market restrictions greatly influence the size of the informal sector: A one-standard-deviation change in these variables raises informality by 0.33 and 0.49 standard deviations, respectively. De Soto (1989) also stresses the role of excessive regulation. Similarly, Loayza, Oviedo, and Servén (2005) conclude that excessive regulation reduces growth and favors the development of the informal sector.

According to Arias and others (2005), excessive labor market restrictions reduce productivity and inhibit the adoption of new technology, harming economic growth. Dabla-Norris, Gradstein, and Inchauste (2008) find that the most important determinant of informal activity is the regulatory framework; they conclude that improvements to this framework, as well as better access for small businesses to certain services, in particular financial services, would allow for a significant reduction in the size of the informal sector.

Gelb and others (2009) confirm this point of view and also expand upon it. In their view, the quality of the regulatory framework and, above all, the capacity of the government to enforce regulations applicable to businesses are major factors in companies’ decision whether to enter the informal sector. In their view, a distinction should be made between two different scenarios: (1) the scenario in which there are educated individuals managing productive firms in the informal sector with significant potential for growth; in this case, improvement of the regulatory framework and better access to services could encourage them to enter the formal sector; (2) the scenario in which the regulatory framework is already good and the informal sector consists only of firms that are developing survival strategies; in this case, helping businesses gain access to social services will at best do no more than maintain their survival. Ingram, Ramachandran, and Vyjayanti (2007) test a probit model that uses perceptions of constraints in the business climate as elements in a cost-benefit analysis for locating in the formal or informal sector. Their results show a robust correlation of formal firms with certain business climate attributes—including access to electricity, finance, and land—but the authors acknowledge that without panel data, these cannot be established as causing formality.

International Competitiveness

An analysis of the business environment in Senegal reveals a number of fairly serious constraints on the international competitiveness of private companies. The modern manufacturing sector appears to be the sector that has paid the highest price as a result of the cumbersome regulatory framework. Over the past two decades, large parts of this sector have nearly disappeared, including the garment industry and the food industry, which are operating in no more than bare survival mode. During this same period, the informal sector has grown in size, so that it forms the foundation for growth, along with certain activities related to vested interests, such as mining, telecommunications, and overprotected manufacturing activities, such as the sugar industry.

The cumbersome business climate manifests itself in various forms: the rigidity of the labor market, the high cost of energy, numerous taxes and fees, and high transportation costs, among other things. The relatively high factor costs, coupled with frequently mediocre quality, is undoubtedly the main factor that explains the poor performance of exports and private investment.

Labor Regulations and Labor Costs

The rigidity of the labor market is a major constraint on the development of formal business activity in Senegal. Golub, Mbaye, and Chwe (2015) ranked 189 countries according to various criteria of labor market rigidity (Table 16.3); and Senegal was ranked 187th out of 189, placing it among the three most heavily regulated labor markets. When one considers the criteria and subcriteria used in that ranking, Senegal is lagging quite far behind. For example, it requires 10 more days of leave than France and 20 days more than the United States and China. Of course, labor market rigidity is at the lower end of the scale in most of the rankings of business climate constraints by severity, but it is certainly a fairly meaningful indicator for private investment.

TABLE 16.3Labor Market Regulation Index and Rank and Share of Firms Rating Labor Market Regulations as a Major Constraint, African Countries
CountriesLabor Market

Regulation Index
Labor Market

Regulation Rank
Firms Identifying Labor Market

Regulations as a Major Constraint (percent)
Anglophone
Botswana0.214114.0
The Gambia0.24583.5
Ghana0.25593.6
Kenya0.3713020.8
Lesotho0.224611.3
Liberia0.30912.6
Malawi0.331054.6
Mauritius0.30928.8
Namibia0.16154.3
Nigeria0.21433.4
Rwanda0.29828.9
Sierra Leone0.298411.4
South Africa0.331085.9
South Sudan0.287210.9
Sudan0.3311113.5
Swaziland0.19299.9
Tanzania0.3712731.7
Uganda0.14718.5
Zambia0.331076.2
Zimbabwe0.511739.6
Average0.287910.2
Francophone
Benin0.3512415.6
Burkina Faso0.287426.0
Burundi0.20392.0
Cameroon0.3612321.5
Central African Rep.0.601888.5
Chad0.4214628.4
Congo, Dem. Rep.0.5518110.4
Congo, Rep.0.5718424.5
Côte d’Ivoire0.371286.1
Djibouti0.4314914.5
Equatorial Guinea0.55182n.a.
Gabon0.3411216.4
Guinea0.31942.5
Madagascar0.531784.6
Mali0.441516.4
Niger0.541795.3
Senegal0.601874.5
Togo0.481643.1
Average0.4414311.8
Other
Angola0.5418026.1
Ethiopia0.341141.6
Guinea0.31942.5
Guinea-Bissau0.481633.5
Mauritania0.4114529.4
Mozambique0.561836.0
Rwanda0.29828.9
Average0.4213711.1
Source: Golub, Mbaye, and Chwe 2015.Note: The labor market regulation index is on a 0–1 scale, with 0 being the least regulated; the labor market regulation rank is out of 189 countries, with 1 being the least regulated. Firms identifying labor regulations as a major constraint are the percentage of all interviewed firms. n.a. = not available.
Source: Golub, Mbaye, and Chwe 2015.Note: The labor market regulation index is on a 0–1 scale, with 0 being the least regulated; the labor market regulation rank is out of 189 countries, with 1 being the least regulated. Firms identifying labor regulations as a major constraint are the percentage of all interviewed firms. n.a. = not available.

The cost of labor is another manifestation of the cumbersome business environment (Ceglowski and others 2015). Table 16.4 shows that Senegal is one of the countries in the sample with the highest labor costs relative to GDP.

TABLE 16.4Annual Manufacturing Wages, Selected Countries in Africa and Other Regions, 2000 and 2010
20002010
Average Wage Level (US dollars)Relative to Per Capita GDP (percent)Average Wage Level (US dollars)Relative to Per Capita GDP (percent)
Sub-Saharan Africa
Burundin.a.n.a.3,26114.9
Cameroon3,0885.3n.a.n.a.
Ethiopia7716.38072.4
Ghana1,8324.9n.a.n.a.
Kenya2,1185.22,8543.6
Malawi4362.82,0455.7
Mauritius3,2540.86,2850.8
Senegal3,6807.86,4506.5
South Africa7,9812.612,3311.7
Tanzania2,2967.51,5813.0
North Africa
Egypt2,0281.33,4531.2
Morocco4,1233.26,6542.4
Tunisia4,0661.85,4551.3
Latin America
Brazil5,8221.610,9181.0
Colombia4,0961.64,6800.8
Mexico8,0481.27,3100.8
Asia
Bangladeshn.a.n.a.6801.6
China1,0161.14,7701.1
India1,3563.02,6191.8
Indonesia9291.21,8970.6
Malaysia4,4051.16,5480.7
Vietnamn.a.n.a.1,7271.3
Eastern Europe
Czech Republic3,9640.712,6730.7
Latvia3,6891.19,1910.8
Poland5,8291.110,1620.8
Source: Authors’ calculations, using UNIDO INSTAT database and per capita GDP from World Bank, World Development Indicators.Note: n.a. = not available.
Source: Authors’ calculations, using UNIDO INSTAT database and per capita GDP from World Bank, World Development Indicators.Note: n.a. = not available.

Infrastructure Quality and Costs

Using the electricity sector as an example, the Doing Business indicators rank Senegal as 170th against other countries in ease of gaining access to electricity. In monitoring of the performance of electric utilities, operating losses in Senegal were found to be equivalent to 30 percent of electricity delivered. Similarly, investment climate assessment surveys indicate that businesses do not rate the quality of the country’s infrastructure services well. Regarding costs, Senegal is among the more expensive countries for electricity (MCC 2016).

TABLE 16.5Indicators of the Business Climate, Selected Countries
Electrical Outages (days per outage)Telephone Connection Delay (days)Days to Clear Imports FromPaved Roads (percent of total roads)
Advanced Economies
Germany0.26.55.4100
Ireland1.715.23.1100
Spain1.010.45.599
North Africa
Algeria5.0174.316.877
Egypt13.989.88.092
Morocco0.73.93.470
Sub-Saharan Africa
Ethiopia24.650.025.314
Kenya13.127.111.814
Mauritius1.938.69.898
Senegal35.78.98.836
South Africa2.018.95.3. . .
Tanzania35.923.214.315
Uganda54.012.87.423
East Asia
China0.34.99.454
Indonesia1.515.33.557
Korea0.0. . .,8.179
Philippines0.612.815.8. . .
Thailand1.415.54.999
South Asia
India24.463.315.250
Pakistan36.523.75.672
Latin America
Brazil1.39.615.314
Chile0.813.311.323
Ecuador0.99.818.215
El Salvador1.68.413.347
Guatemala2.37.712.759
Peru0.88.720.414
Eastern and Central Europe
Czech Republic1.222.59.2100
Estonia1.221.03.118
Hungary0.911.53.338
Poland0.954.39.570
Romania4.115.52.557
Russia0.919.619.3. . .
Slovenia1.013.83.1100
Source: World Bank, World Development Indicators 2015.Note: . . . = not available.
Source: World Bank, World Development Indicators 2015.Note: . . . = not available.

The Role of Taxation

Surveys indicate (Mbaye and others 2014) that businesses in Senegal are discontented with tax levels and tax administration and have low levels of confidence that the government makes good use of public revenue. All of this contributes to low tax morale in the country.

The role of business taxation in competitiveness and growth is widely recognized and documented. In the countries in question, however, it appears to be more of a constraint than a factor favoring a company’s development. According to many authors, the expansion of the informal sector is nothing but the result of an incoherent tax policy that aims to maximize the collection target rather than to provide support and assistance.

In Central Africa, as in West Africa, the proportion of businesses taxed according to an accounts-based tax regime (régime du réel) is relatively low: in Cameroon it is 33 percent in Douala and 27 percent in Yaoundé; in Gabon it is 21 percent in Libreville (Mbaye and others 2015). Under such a tax regime, a company is required to provide all accounting and financial documentation related to its activities to allow the tax authority to determine its tax contribution in the most objective and reliable manner. For all those companies not subject to the accounts-based tax regime, the transparency needed by the tax authority to make an informed determination of a company’s taxable income does not really exist. Thus, in francophone African countries the largest direct tax collections come from the minority of companies that are subject to the accounts-based tax regime, particularly those that are operating under the regime applicable to large companies. There is clearly a lack of tax fairness at work here, in which the entire burden of collection is placed on the shoulders of a minority of companies.

In general, the perception that company managers in francophone Africa have of the tax system is fairly negative, and this is true for all categories of companies, in both the formal and informal sectors of the economy. The length of the queues for the settlement of taxes is considered to be abnormally long by most company managers. In general, the methods for the settlement of taxes, such as the quality of the collection service, are considered to be inefficient. Likewise, the tax rates applicable to companies are considered to be high by many companies.

There are, however, some positive perceptions of the efficiency of the collection service as well. A majority of those surveyed by Mbaye and others (2014) noted the efficiency and ease of declaring one’s taxes and reported few obstacles in the registration process. In addition, a significant number of operators in both the formal and informal sectors find that it is not always advantageous to move into the informal sector because it is then not possible to avoid bearing the costs of the value-added tax or to access public or international markets.

Survey results (Mbaye and others 2014) also indicate a very low level of confidence in the government’s management of public funds and its use of tax proceeds (Figure 16.2). Many of the managers surveyed reported that the fact of paying their taxes exposes them, as taxpayers, to fiscal harassment (Figure 16.3). Finally, the low collection rates can be explained by the limited capacities of the governments to enforce their own regulations (Figures 16.4 and 16.5). The fact that a majority of operators believe this is enough to explain the scale of tax evasion in francophone countries.

Figure 16.2.Business Survey Responses Concerning the Government’s Use of Tax Revenue and Confidence in the Use of Public Resources, by Business Income Level

(Percent)

Figure 16.3.Business Survey Responses Concerning the Perception That Tax Payments Expose One to Fiscal Harassment, by Business Income Level

(Percent)

Figure 16.4.Business Survey Responses Concerning the Level Enforcement and Honesty of Tax Filing, by Business Income Level

(Percent)

Figure 16.5.Business Survey Responses Concerning the Quality of Tax Collection Services, by Business Income Level

(Percent)

Unfair Competition from Informal Sector

In Senegal, as elsewhere, the informal sector is very heterogeneous and strongly connected with the remainder of the economy. The relationship between the formal and informal sectors is either competitive or complementary, depending on the industry. In some sectors, such as the distribution of drugs, gasoline, or used cars, we observe a strong competition that favors the informal sector, owing to its lower prices, even though it is to the detriment of quality (Mbaye, Benjamin, and Gueye 2017).

An Approach to Improving the Contribution of the Informal Economy

Despite their exploitation of looser regulatory practices, informal firms have lower productivity than formal ones. Most studies on informal firm productivity show that informality is associated with lower growth as well as lower productivity. Results from Benjamin and Mbaye (2012b) corroborate the negative correlation between informality and productivity for firms in West Africa. In addition, when informality is broken down into different degrees along a continuum, the levels of formality and productivity are strongly and positively correlated. Similar results are found in Cameroon, although the sector of operation is also found to have a significant role.

Nevertheless, the diversity of the informal sector indicates that its performance can be improved by means that vary with the respective segments of the sector (such as large firms, small firms, and so on) (Benjamin and Mbaye 2012a; Benjamin, Golub, and Mbaye 2015).

The strong heterogeneity among informal firms has led to the approach of classifying firms according to a continuum of characteristics. This heterogeneity points to policy options that involve different approaches for firms in different segments of the spectrum. Further, it allows us to make use of observations to identify which aspects of firm performance—productivity, profitability, employment, longevity—can be improved along the spectrum, without restricting either policy or results to a simple formal-informal dichotomy. While all of these aspects of firm performance are important, the issues of productivity and employment have the greatest social impact. Informal firms have been shown to have lower productivity than formal firms in countries studied. The reasons for this and the best policy response to encourage informal firms to upgrade and improve their performance, however, have not been thoroughly investigated.

Many efforts to improve firm performance have focused strictly on elements of the production function (more labor skills, cheaper credit) while treating government mainly as a cost (taxes, cost of compliance with regulations). Yet research on informality reveals that many characteristics of the public regime—not only the rules, but the nature of enforcement or lack thereof—along with the quality of public services, governance, political privilege, state failures, and many other institutional features that characterize “the system” strongly influence the decisions of firms regarding informality. Further, while firms want better governance and better public services, governments want better tax compliance, and so do compliant taxpaying firms.

Elements of a Public-Private Deal to Improve Civic Participation

The preceding considerations lead to the following recommendation: Launch the kind of practical public-private dialogue that can reveal elements of a public-private bargain that enhances both public performance and private contributions to public finances. Such a dialogue toward this mutual need for reform must include actors from the informal economy and not be confined to constituents focused on defending the status quo. In Senegal, such a deal might emphasize the following issues.

Increasing Cooperation across Informal Firms

The lack of accurate accounts—or the unwillingness to provide accurate accounts to tax authorities—represents a key gap in behavior between formal firms and large informal firms that could be formalized. It is noteworthy that the Association of Francophone Accountants chose the informal sector as the theme for its 2014 annual meeting. And while it can be allowed that accountants are the ones pressured to prepare accounts in ways convenient to business owners, it was the strong preference of the accountants at that meeting to bring more companies into conformity with international accounting standards. The community of accountants seemed to be seeking help both from government and from agreement within the private sector to bring a critical mass of similar large, sophisticated informal firms into such conformity, an agreement that would need to be implemented by the entire class of firms. The accountants also identified entrepreneurial skills, business climate reforms, and finance as critical areas of focus for reform.

Building Entrepreneurial Skills

The management of the informal economy requires, first of all, the implementation of a comprehensive and ambitious entrepreneurial policy, which should aim not only to foster an entrepreneurial spirit, but also to establish mechanisms to increase the entrepreneurial success rate. At least three out of five small and medium-sized businesses do not survive three years. Among the countless reasons that explain this catastrophic failure rate, we can mention insufficient financing, a lack of planning, excessive debt, poor cash management, inexperience, failure to comply with legislation, or even an inability to innovate, all of which are seen on a recurring basis.

These factors contributing to failure clearly show that most entrepreneurs are not always equipped to validate their business plans, much less to start and operate a business in an environment that is governed by standards and is sometimes hostile. The entrepreneurial policy that is to be defined could be focused on four points: professional training in starting a business; incubation facilities for startups; grant, subsidy, and loan programs at different stages in companies’ life cycle; and support services.

Improving Priority Elements of the Business Climate

Two elements of the business climate in Senegal stand out as deserving priority attention. First, there is a need to improve coordination among the diverse registration and tax authorities, especially between customs and tax offices, and to better enforce single-taxpayer identification systems, which would help to improve the investment climate and reduce the governance issues that give rise to the country’s large informal sector. Second, business and government should collaborate on an agreement to improve both the business environment and the tax base, in recognition that each side can take actions that will improve the circumstances of the other.

Adapting Finance to the Local Business Risk

The results of surveys of informal businesses in Senegal and other West African countries show overwhelmingly that these business owners prefer to rely on self-financing or financing from family (Figures 16.6 through 16.8). Evidence from investment climate assessments and other sources indicates that even when firms—including sophisticated informal firms—are eligible for bank loans, they are not inclined to take them, thus exercising what may be called voluntary self-exclusion from the formal credit market. Even when programs are instituted to increase the supply of microcredit, the take-up rates are often weak. Those who do undertake such formal loans struggle mightily to service and repay them.

Figure 16.6.Percentage of Formal and Informal Firms Financed by Internal Funds or Retained Earnings

Figure 16.7.Percentage of Companies with Bank Financing

Figure 16.8.Percentage of Companies with a Family Loan

These are all indicators of the fact that informal sector entrepreneurs face very high business risks. The default risk on loans is high, and these business owners cannot afford to forfeit collateral. Thus, by financing through their own savings or borrowing from relatives, default risk is somewhat diversified, because relatives are more likely to find some accommodation that does not result in seizing collateral. In view of the strong revealed preferences for borrowing from people one knows personally and for diversifying default risk, programs to increase the supply of financing should take account of these preferences. For small but promising informal firms, a program of grants may be more appropriate in the early stages.

Interest rates are high in West Africa, as they are in Central Africa, with informal businesses facing rates that are especially high (Figure 16.9). Formal companies in Cotonou, Dakar, and Libreville are generally faced with rates of about 15 percent, while for formal companies in Douala and Yaoundé, the rates are above 20 percent. Informal businesses have to live with rates in the neighborhood of 20 percent in Libreville and as high as 50 percent in Douala and Yaoundé. The higher rates paid by informal businesses can be explained by the higher level of risk associated with these loans and by the high operating costs borne by the microfinance institutions that do the most lending to these businesses.

Figure 16.9.Interest Rates Charged by Banks on Loans

(Percent)

In West Africa, all of the businesses surveyed acknowledged having a great deal of difficulty repaying their loans, while businesses in Douala and Yaoundé appear to have fewer problems in this regard, with 30 percent and 25 percent, respectively, reporting difficulties in this area. Formal businesses report having fewer difficulties in the repayment of loans than informal businesses in all of the countries in the sample, with the exception of Benin (based on Cotonou data) (Figure 16.10).

Figure 16.10.Percentage of Companies Having Difficulty Repaying Loans

Conclusion

Policy toward the informal sector matters, not only because of this sector’s share in the total economy but also because of the size and nature of the informal labor force. Thus, progress in the informal economy is essential to inclusive growth and to the fortunes of small and medium-sized enterprises. Informal firms have been consistently found to have lower productivity than formal firms, though the largest productivity gaps are among small informal firms. Yet even small informal firms can improve their productive performance with some help and with improvements in the business climate.

As indicated in this chapter, the prevalence and behavior of informal firms in Senegal is strongly influenced by the investment climate. Options exist for reforms in labor regulations, lowering infrastructure and energy costs to bring down the cost of doing business and providing more formal options for the larger and more sophisticated domestic firms. Improvements in the judiciary, tax systems, and public expenditures have the potential to increase the incentives for these firms to modernize their practices and raise productivity. However, large informal firms are unlikely to increase their public contributions without a public-private accord that ensures that other firms like themselves will observe the agreement and that the government will deliver better public services, a better business climate, and better use of public resources in exchange for higher tax payments from the informal sector. And even though small informal firms have little to offer in public funds, programs to improve worker training and entrepreneurship skills can enhance their business practices and the climate for competition among them.

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