Impact Assessment

The Demand for, and Consequences of, Formalization among Informal Firms in Sri Lanka, 2012

    Description
    The authors conduct a field experiment in Sri Lanka which reduces the information costs and increases the monetary benefits of formalizing in order to measure the latent demand for formalization, and the consequences that formalizing has on informal firms.

    Methods for info gathering
    The authors divide a sample of informal firms with 1 to 14 paid employees into four treatment groups and a control group. The first treatment group are given information about the costs and benefits of, and procedures for, registering their firm at the division level with the Divisional Secretariat (DS) – the relevant registration for tax purposes. Additionally, they are reimbursed for the (modest) direct cost of registration if they registered. The second, third, and fourth treatment groups are provided the same information and also offered a payment of 10,000 Sri Lankan Rupees (LKR), 20,000 LKR and 40,000 LKR (approximately US$88, $175 and $350 respectively) to register. Three follow-up surveys of these same firms are conducted at 15, 22 and 31 months after the intervention, enabling an examination of whether and how the firms benefited from formalization.

    Summary of results
    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 and 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.

    Follow up surveys, looking at the affects of formalising, show that though 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.