78241 Finance & PSD Impact MAY 2013 The Lessons from DECFP Impact Evaluations ISSUE 24 Our latest note highlights the results from a collaboration with a state government in Brazil that was designed to test different policy options for bringing informal firms into the formal sector. A Helping Hand or the Long Arm of the Law? Do carrots or sticks work best for bringing informal firms into the formal sector? Gustavo Henrique de Andrade, Miriam Bruhn, and David McKenzie Since 2004, 75 percent of countries were still informal. As a result, the State have adopted at least one reform making it Government wanted to test several easier to register a business. Yet, despite competing mechanisms for reducing these efforts, the majority of firms in most formality. developing countries remain informal. This is of concern to policymakers, who worry The Interventions and Experiment that a large stock of informal firms results in In early 2011 we conducted a listing a loss in tax revenue, unfair competition for survey of more than 10,000 businesses in formal firms, and a culture of informality. 600 census blocks of Belo Horizonte. These Spurred by the work of Hernando de businesses were then matched against a list Soto and Doing Business, most of the policy of registered firms, with those that could not attention to further reducing informality has be matched comprising a sample of 7,852 been devoted to further helping firms to potentially informal firms. These firms were formalize by continuing to lower the costs then randomized into five different groups: and complexity of formalization. Much less 1. Control Firms: 201 census blocks, attention has been given to increasing the containing 2,810 firms were the control costs of remaining informal through better group and received no intervention. enforcement of existing laws. 2. Communication Treatment: 331 firms A field experiment conducted with were given information about how to the State Government of Minas Gerais in the register and a helpline to call. city of Belo Horizonte in Brazil provides an 3. Free Cost + Accountant Treatment: 328 opportunity to test the relative merits of firms were given information about how to further cost-reduction versus enforcement in register, had approximately US$200 in formalizing firms. registration fees waived, and offered one year of free (mandatory) accounting Context services. Brazil began a process of 4. Inspection Treatment: 577 firms were simplification of firm registration in 1996 assigned to receive a visit from a municipal with the introduction of the SIMPLES tax inspector, who would check proof of a system which consolidated multiple taxes municipal license, and follow-up if they did and contributions into a single payment, and not have one. also lowered the tax burden on small firms. 5. Indirect Inspector Treatment: 593 firms Within Minas Gerais, the Minas Fácil in the same census blocks as the inspection service was started in 2005 with the purpose treatment firms were used to test whether of additionally reducing the number of having a neighboring firm inspected has procedures and time taken to start a spillover impacts. business. However, despite these efforts, survey data from 2009 revealed that 72 percent of firms Do you have a project you want evaluated? DECRG-FP researchers are always looking for opportunities to work with colleagues in the Bank and IFC. If you would like to ask our experts for advice or to collaborate on an evaluation, contact us care of the Impact editor, David McKenzie (dmckenzie@worldbank.org) Data  We find no spillover impact of A baseline survey was taken of the inspections on other firms, which is control, communication, and free cost firms. consistent with survey data showing The most common firm types were bars, that firms don’t talk that much to restaurants, hairdressers, mechanics, neighboring firms, and don’t notice clothing, and grocery stores. The average about half the inspections that take firm owner had been in business for 8 years, place. had 1.3 employees other than him or herself, and monthly profits of about US$1000. The Implications focus of the experiment was on the firms The process of registering in Belo with fixed premises, not the smallest Horizonte still requires more steps and informal firms. complications than in a number of other A follow-up was then taken of all countries that have pursued entry reforms. firms between July and September 2012, Moreover, in addition to facing taxes, firms reaching 56% of targeted firms, with 14% which do register face a relatively large cost closed down, 20% of owners absent, and in terms of the need to hire an accountant. 10% refusals. Administrative data on Faced with these costs of being formal, it formalization enables us to measure appears few informal firms want to formalization outcomes for the full sample, formalize unless they are forced to do so by regardless of whether or not they attrit from enforcement. the follow-up survey. Our findings suggest sticks rather than carrots seem more effective at getting Results firms to formalize in this context, but also  The communication and free cost show limits to this approach – many of the treatments increased firm owner firms assigned to get inspections were never knowledge about the need for found by the inspectors, and informal firms accountants; but had zero impact on the inspectors closed down were found open registration for SIMPLES or a again by the time of our follow-up survey. municipal license. Coupling simplification with better  The free cost treatment actually enforcement therefore seems a way forward. reduced formal registration through a Cost-benefit analysis suggests more simpler micro-entrepreneur category, enforcement would pay for itself in terms of which had its eligibility criteria higher tax revenue, but that the fact that loosened during our study period and revenue gets split among the federal, state, which had not been discussed in the and municipal governments lessens the information provided to firms. incentive of the municipality to pay for more  Direct inspections had no impact on inspections. Further experimentation as to the probability a firm closed down, how to better improve the process of but did increase municipal enforcement of regulations therefore seems registration. We estimate that one an important area for policy and research additional inspection leads to a 21 to efforts going forward. 27 percentage point increase in municipal registration. For further reading see: Gustavo Henrique de Andrade, Miriam Bruhn and David McKenzie (2013) “A Helping Hand or the Long Arm of the Law? Experimental evidence on what governments can do to formalize firms� World Bank Policy Research Working Paper no. 6435 Recent impact notes are available on our website: http://econ.worldbank.org/programs/finance/impact