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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.
