Temptations of the informal economy: pros and cons
Published on 03/15/2023
Published on 03/15/2023
A successful company draws on a rich mix of the right ingredients added at just the right time. A study by three NEOMA researchers – Bisrat Misganaw, Dawit Assefa and Ana Colovic – has shown that starting a business informally, i.e. without reporting it to the authorities and before registering it, can be a key ingredient in the recipe for success in some countries.
Would companies be better off flying under the radar of the authorities? The informal economy is a type of underground economy that affects countries worldwide. It is typified by activities that are not formally registered with the relevant government agencies, and it operates in most sectors, including agriculture, construction and the service industry. Contrary to the popular image, informal enterprises do not simply perform “odd jobs”: nowadays they are increasingly involved in developing new technologies and related services. In practice, these businesses do not pay any form of tax; at the same time, they do not benefit from legal or social protection.
The informal economy, which is not a new phenomenon, exists in different societies to varying degrees. In fact, up to 50% of businesses in developing countries operate in the shadows compared to 15% in the member states (including France) of the Organization for Economic Co-operation and Development (OECD). But businesses do not necessarily operate indefinitely outside the legal framework. Some entities that begin life as unregistered companies ultimately acquire legal status after several years. Against this background, the NEOMA researchers decided to ask the questions: What mechanism gives the best results in terms of operating formally / informally depending on the country? How does the number of years spent operating undeclared impact a company’s growth?
The literature includes two types of business scientist with opposing views on starting up a company: those who are “pro-formal” and those who “pro-informal”. Each of the two categories makes solid arguments. First, the pro-formals: they consider that operating legally helps a company gain recognition, making it easier to recruit employees and access public services, such as protection by the courts in the event of a dispute. The pro-informals, on the other hand, champion the idea that registering with the authorities in the start-up phase stunts growth. An informal start-up can redirect money usually earmarked for the authorities (taxes, registration fees, etc.) to expanding the company. In addition, it was found that start-ups are more reliant on their leaders’ networks than on public services to obtain resources and gain legitimacy.
In reality, the relationship between initial informality and long-term performance is not linear – so concludes the NEOMA research into over 49,520 companies from 116 countries. While the scientists argue that starting a business informally almost always benefits its development, this is only true to a certain point. After 7.52 years operating in the shadows, the advantages of informality become insignificant. Why? Due to the increased costs needed to keep the company afloat, limited access to external resources, and a personal network that burns out after a finite period of time.
These results, however, are heavily influenced by the quality of the government agencies in the country where an entity is located. This observation partly explains why the phenomenon of the informal economy is more widespread in developing countries.
Developing countries labour under a sometimes complex system of bureaucracy with few advantages for new businesses. In fact, the context pushes business owners to operate in the shadows when they start up. And yet, the researchers show that the poorer the quality of the government agencies, the more it is in a company’s interests to operate for a long period without being officially declared. Developed countries, by contrast, benefit from robust, clear regulations backed up by stable agencies that limit this effect. As a result, the authors of the study alert policy-makers to the limits of their systems.
However, introducing tougher penalties to ratify undeclared activities – a strategy adopted by developing countries – would not be enough in itself. So, what can be done to facilitate the switch to the formal sector? The NEOMA researchers advocate that governments organise alternative resources. Based on an approach that is more carrot than stick, the idea is to encourage companies to become legal by swelling the associated advantages. Examples would include streamlining and cutting the costs of registering a company or offering business owners benefits such as training. The challenge is to reduce the number of undeclared companies so they can contribute fully to the local and national economy.
Bisrat A. Misganaw, Dawit Z. Assefa, Ana Colovic. (2023). Is starting and staying unregistered longer beneficial for firms? The moderating role of institutional quality. International Journal of Entrepreneurial Behavior & Research, Vol. 29 No. 2, pp. 433-458. . https://doi.org/10.1108/IJEBR-07-2022-0582