Why businesses opt to operate informally

by Business Times writer
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Informal businesses, prevalent in both developed and developing economies, operate outside formal legal and regulatory frameworks. 

Typically identified by their lack of registration, absence of tax payments, and use of informal labor, these businesses play a significant role in economies globally. Despite their contributions, informality has negative implications for tax revenue, sustainable development, and overall economic growth. 

Governments worldwide push for the formalization of businesses to boost revenue generation and ensure financial stability. Formalizing businesses involves transitioning these informal ventures into legally recognized and regulated entities.

This strategy aims to expand the tax base by integrating informal businesses into the formal sector, as informal enterprises often evade direct tax contributions. 

This process involves registering with governmental authorities, complying with tax obligations, following labor regulations, and securing requisite licenses and permits.

Globally, a significant portion of economic activity operates within the informal sector.

According to World Bank and ILOSTAT 2022 report, Uganda exhibits a similar trend with about 72% of businesses, 78% of the labor force, and about 51% of GDP generated from the informal economy.

Why Businesses Choose Informality

According to Makerere University think tank, the Economic Policy Research Centre (EPRC), “informality is linked to lack of information and awareness about the importance of business registration, and the high compliance costs associated with business registration and obtaining licenses which discourage informal firms from formalizing.”

Formal registration entails various expenses, including fees for registration, obtaining licenses, and dealing with bureaucratic processes. These requirements can be particularly burdensome for small businesses, especially those in their early stages, as they may lack the financial resources and administrative capacity to navigate these complexities.

In contrast, informal businesses enjoy the simplicity of starting without these formalities, which can be appealing for entrepreneurs seeking to avoid initial financial strain and administrative hassle.

The EPRC’s 2022 assessment of informal businesses in Uganda reveals that about 56% of informal businesses in Uganda are unaware of the significance of registering their businesses and where to get information on registration.

Additionally, the report shows that the high registration cost and licensing fees by Uganda Registration Services Bureau (URSB), Uganda Revenue Authority (URA), and the local authorities has exacerbated the problem. This is further worsened by bureaucratic inefficiency in the registration process due to long duration and delays in obtaining trading licenses upon submitting all requirements and payment of requisite fees.

Furthermore, the assessment reveales that the “complexity of tax return filing and obtaining Tax Identification Numbers (TINs) adds to these costs.”

Formal businesses are subject to taxation on their profits. However, the tax obligations can be unpredictable and may impose financial strains on businesses, especially during periods of economic uncertainty. Informal businesses often operate outside the purview of tax authorities, allowing them to evade or minimize tax liabilities. This flexibility can be advantageous, particularly for businesses operating in volatile economic environments seeking to maintain financial stability.

Relatedly, Formal businesses are obligated to comply with various regulations, including labor laws and safety standards, which can incur additional costs and administrative burdens. These requirements are designed to protect workers’ rights and ensure workplace safety but can be financially burdensome for businesses, particularly small enterprises with limited resources. In contrast, informal businesses operate with greater flexibility, often disregarding regulatory requirements to minimize costs and administrative burdens. 

Impact Of Informality On Economies

Informality reduces the tax base, as informal businesses often evade or minimize tax obligations. This deprives governments of revenue needed to fund public services and infrastructure development. The reliance on a smaller tax base can also lead to higher tax rates for formal businesses and individuals, further discouraging formalization and perpetuating the cycle of informality.

“Most informal businesses tend to operate outside the formal regulatory frameworks, making tax information inaccessible. Informality thus, poses challenges to effective tax revenue collection, thereby eroding the government’s ability to provide public goods and services,” EPRC assessment reveals.

According to the Ministry of Finance, Planning and Economic Development, informality costs the economy about 40% of GDP annually due to tax evasion.

EPRC assessment found that informal businesses in Uganda withhold about shs. 474 billion in potential tax revenue by operating in legally or fiscally informal ways.

Additionally, Informality has implications for the labor market, including lower wages, limited job security, and inadequate social protections for workers which hampers sustainable development. Informal sector workers often lack benefits such as health insurance, pension contributions, and labor rights, leaving workers vulnerable to exploitation and economic shocks.

The wage disparity between informal and formal sector workers contributes to overall economic inequality and suppresses the growth potential of countries with sizable informal sectors.

According to the Private Sector Development program of the National Development Plan III, Uganda envisages to reduce the size of the informal sector from 51% to 45% by 2025.

Contribution Of Informal Businesses To The Economy

As of December 31, 2020, informal businesses generated income amounting to shs. 41,280 billion shillings, an equivalent of 28.7% of the aggregate GDP.

Disaggregation by gender suggests that shs. 29,160 billion which is 70.6% of the revenue by informal businesses, is generated by women, which is consistent with the assertion that suggests that women dominate informal businesses. 

A disaggregation by industry revealed that the trade sector contributed shs. 27,480 billion, which is the largest amount by any single sector and this is 66.6% of the total informal business contribution.

Hotels, restaurants and eating places came second with a contribution of shs. 5,376 billion, which is 13% of the total informal business GDP. 

Most informal businesses are in the trading and the hotel, restaurant eating places industry.

What Can Be Done To Reduce Ingormality?

“Digitization of business registration and tax processes, along with harmonization of registration forms, could ease the burden,” EPRC recommends.

It also recommends elimination of excessive regulations and bureaucratic requirements. This motivates informal firms to formalise.

“Establishing one-stop registration centers at the local level and leveraging business associations such Kampala City Traders Association (KACITA), Uganda Manufactures Association (UMA) and Uganda Small Scale Industries Association (USSIA) can facilitate registration and encourage formalization.”

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