Why should firms enter the formal economy?

Grace Wallace

At the 329th General Body, the International Labour Organisation (ILO) will discuss the 2015 recommendation to formalise the informal economy. It is necessary to understand how the ILO proposes to incentivise firms who are already operating outside the law to formalise their workforce.

Work in the informal economy is neither legally protected nor regulated by the state. Workers in the informal economy lack basic social and employment protections and access to collective bargaining to represent or voice their concerns. They do not have formal employment contracts, which means their hours can be stopped with no explanation, and often have poor working conditions. While informal employers have access to a flexible workforce and can avoid the costs and liabilities of the formal economy, their ability to cut costs comes at the expense of workers.

Small to medium enterprises (SMEs) are thought to be one of the main actors in the informal economy, operating at the low-value adding stage of the production chain. It is estimated that there are 420 to 510 million SMEs worldwide, of which only 9 per cent are formal. As much SME production is low-value adding, to make a profit they minimise costs by using cheap labour. Fewer regulations and limited social protection enables lower production costs.

The majority of informal workers in this sector are poor and vulnerable. These workers find they are trapped in the informal economy as the work offers few opportunities for career progression and the absence of state protection means that these workers have limited bargaining power to improve standards.

It is important to understand how the ILO proposes to create incentives for SMEs to formalise, as currently it appears the workers are the only ones who will benefit from being in the formal economy.

What are the benefits of formalisation?

Being a SME that operates in the formal economy would increase opportunities to improve the firm’s market position. As a legally formal SME, it would be able to access new markets and expand into international markets through exports. Formalising would increase an SME’s credibility and customer trust. This would be particularly good if those customers are multinational corporations (MNCs) seeking to improve their corporate responsibility by operating with legally obliging subcontractors.

However, these arguments sound very idealistic to the traditional SME who would face an expensive and bureaucratic process to formalise their business. In addition, many of the opportunities are reserved for the lucky few who work with socially responsible MNCs. The majority of SMEs are competing among themselves to sell their products locally, rather than operating in international markets. At a local level, low prices are prioritised over socially responsible goods. On the whole, it is still only the workers who would benefit. This comes back to the original conundrum, how does the ILO propose to incentivise firms to formalise?

What incentives can be created?

In 2014, the ILO noted that a number of countries have incentivised their SMEs to formalise by simplifying their labour laws and procedures. This included reducing or eliminating the cost of registering enterprises with the authorities. Furthermore, they simplified the procedures for hiring workers to make it easier and more transparent for SMEs, who were unfamiliar with the process.

Case studies illustrate the success of these incentives. In 2010, the General Act on SMEs in Brazil created the legal concept of “individual micro-entrepreneur” and simplified registration. Firms gave a single contribution which then gave their employees access to social security, medical care and maternity leave. By making the process of formalisation cheaper and easier, the ILO could incentivise firms to enter the formal economy.

Conclusion

Therefore, it is possible to create incentives for SMEs to enter the formal economy. However, due to the sheer number of SMEs and workers that operate in the informal economy, it will be interesting to see how the ILO proposes to successfully incentivise and benefit all SMEs.

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Grace Wallace is a final year undergraduate student at the University of Sheffield where she is studying for a BA in Economics and Politics.

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