Fiscal Strategy, the informal sector & the jobs agenda: An evidence-based policy perspective

Policy arguments about what drives economic growth have traditionally focused on capital, infrastructure and innovation, inter alia. There is no question the crucial role that such fundamentals play in building a competitive private sector. What seem to be missing from the policy discourse however, is the large size of the informal sector and what it means for output and jobs growth. The prevailing theory is that formalization leads to measurability in ways that enable creditors to evaluate risks and also allow policy makers to forecast outcomes of program interventions more accurately. According to Enterprise Surveys, The World Bank (Ghana: Country Profile, 2013, p.14), 23.5% of manufacturing businesses in Ghana (compared to 18.7% average in sub-Saharan Africa and 14.7% in comparator lower-middle income countries) commenced operations without business registration. Although a limited gauge, percentage of registered manufacturing businesses represent a microcosmic view of the size the informal sector. According to Ghana Statistical Service (GLSS 6, p.49), the informal private sector employs 41.9% of all employed persons (15years+) notwithstanding the fact it lacks favorable access to finance, unlike its formal sector counterpart. The result is low investment into fixed assets, stunted growth and vulnerable employment for majority of Ghanaian workers.

Undoubtedly, the top policy priority for the next political administration would be the issue of unemployment. It is our considered view at Rural Heights Foundation that a well-rounded policy response must include strategies to progressively formalize the informal sector. This will widen the revenue base, protect vulnerable employees and address the free-rider problem.

So what is responsible for the large informal sector? A review of related literature (see www.ruralheights.org/publications for full paper) suggests an evolving theory, which is that, informality is influenced by cost (start-up), necessity and taxation - all of which have implications for capital market participation. It is therefore consistent with theory to argue that credit to the private sector (as ratio of GDP) is inversely correlated with size of the informal sector.

Empirical Evidence from 28 Economies
In a bid to gain a firmer grasp we developed two hypotheses from our study of existing literature. We subsequently collected data (credit to private sector/GDP) from World Banks’ Global Financial Development Database 2015 and Enterprise Surveys, to cross-reference with data (business registration cost and total tax rate) from Doing Business Report 2015, in order to answer one basic question: Does business registration cost and taxes have any impact on size of the informal sector?

Here is what we found;
1. Private sector credit/GDP is strongly and inversely correlated with total tax rate (as percentage of profit). Data set chosen from high income OECD and non-OECD economies showed a Pearson Correlation Co-efficient r = -0.55 and r = - 0.60 respectively (p>0.05).

2. Cost of starting a business (as percentage of income per capita) is inversely correlated with value of private sector credit/GDP. This affirms the theory that if start-up cost (business registration) is high, more businesses will choose to become informal resulting in limited funding opportunities from the financial sector.

3. Average credit to private sector as percentage of GDP for the last 15 years (2000-2014) in economies with small informal sector (incidentally all High Income countries) were above the 50^th percentile (except Argentina, 12.4%; Russia, 31.02%). We deem this to be an effect, not a cause.

Fig.1

Based on these findings we concluded on the basis on the evidence that an entrepreneur’s choice of doing business in the formal or informal sector, is heavily influenced by taxation and business registration (regulatory) cost. See Fig. 2.

Fig 2. Pearson Correlation Co-efficient (Lower Middle Income Economies)

Fig.3 Informal Sector Integrative Growth Model

Policy Recommendations
The next political administration must be clear in terms of its growth strategy. Any policy strategy for job creation which discounts the informal sector as the fulcrum of growth will experience limited success at best.

We make the following key recommendations:

1. Reduce tax burden on businesses with more generous concessions for manufacturing and agro-processing.
2. Credit creation depend on a bank’s ability to mobilize cheap deposit. VAT/NHIL on basic banking services dissuade the use of banking services and therefore adversely affect the loanable fund pie. It makes sense to scrap VAT on banking services.
3. Optimize processes at Registrar-General’s Department to reduce cost and float time. Web and mobile application technology deployment must be considered, particularly for front-end processes. It currently takes a minimum of 30 days (contrary to the 14 days as reported in the Doing Business Report 2015) to jump through 8 procedures with an attendant cost that stands at 19.2% of per capita income.
4. Engage with private sector stakeholder groups regarding the areas for legal and corporate governance reforms.
5. Fixing the macro-economy as a basic precondition is a presumption.

About Rural Heights Foundation
Rural Heights Foundation is a nonprofit organisation that blends the advocacy spirit of a policy Think Tank and the conscience of social interventionism in the area of well-being, education and enterprise. Our broader mandate is to help reduce incidence of poverty in rural Africa through direct interventions and sound policy advocacy within 5 thematic areas; participatory governance, institutional reforms and youth entrepreneurship development.

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URL: www.ruralheights.org