Globally, it is estimated that approximately 1.3 billion people are working within the MSME subsector. However, huge number (between 414-466 million) of these MSMEs are not formalized. These are unsurprising statistics, especially when viewed in the context of emerging economies like Africa. This is because, in most part of Africa, informal enterprises are not an option, but rather, an unintended destination for all start-up MSMEs.
Studies by the World Bank and other International Development Organizations estimate that, MSMEs contribute to over 30% to GDP and more than 70% of all jobs creation in developing countries. However, these MSMEs are existentially challenged in various fronts, including but not limited to business formalization.
What is MSME formalization? And what governmental policies that best encourage MSMEs to become formalized? Are there material benefits to MSMEs who become formalized?
Informal MSMEs refer to businesses (usually run by women, youths, and marginalized people) which have otherwise not been licensed or registered at the registry of national, provincial or municipal authorities. And that, owners and workers of such businesses are not tax compliant, nor covered with social security, and other relevant labor laws in the jurisdictions where they operate.
According to the ILO, informal enterprises (MSMEs) refer to “all economic activities by workers and economic units that are- in law or practice- not covered or sufficiently covered by formal arrangements”. To formalized your business, thus, means to license, and register it at the registrar of businesses, to become tax and labor-laws compliant, and also obedient to social security laws.
In general, business formalization has several huge advantages inured to the benefit of MSMEs. These benefits, include, but not limited to, access to finance, improved productivity, access to wider markets, business development services and access to technology. Others include; avoidance of punitive state fines, improved corporate image, increased business competitiveness and so on. For example, formalized MSMEs have comparative better chances of bidding and wining (minor) government contracts to increase their revenue base.
In fact, the ILO contemplates that, formalizing MSMEs would help accelerate achievement of SDG 8. To this end, the ILO has made clarion calls on all governments to take innovative steps and policies to transition and integrate all informal MSMEs into the formal economy- in order to guarantee decent jobs and sustainable economic empowerment.
But why are so many MSMEs in Africa not formalized (or at least willing to initiate it)? Are they not interested in the intrinsic benefits of formalization? The answers are not far-fetched; cumbersome formalization processes, unfriendly legal provisions for compliance, little or no incentives for formalization, poor sensitization for formalization, and trust and credibility issues around formalization promises are suggested answers.
In order to propel MSMEs to become formalized, governments and relevant authorities must adopt proactive steps such as “make it easier” to register and comply, incentivize formalization, intensify sensitization and deliver on formalization promises to achieve this purpose.
Governments and policy makers must take soft approaches in order to make it easier for the MSMEs to register and comply. These approaches must include; decentralizing enterprise formalization centers, and digitize formalization processes (including electronic licenses renewals, tax and social security registrations and payments bundled with mobile money services).
These steps are particularly important because, informal MSMEs (most of whom are predominantly illiterate or semi-literate, but replete with brilliant business ideas) are sometimes frustrated at formalization centers (often located only in the cities) and the rigmarole formalization processes understood only by the educated few. For these MSMEs, leaving their shops/businesses away for longer periods to attend to formalization processes is an unthinkable trade-off.
Formalization incentives is yet another great policy that encourages MSMEs to become formalized. With this, MSMEs are exceptionally given soft and subsidized conditions for formalization.
Incentives such as reduced business registration or licensing fees, zero tax holidays, improved access to public procurement opportunities and government grants, and subsidized interest rate on bank loans, are thought to have direct measurable financial impact on their profit margins of MSMEs, and hence could easily quantify the direct financial and non-financial benefits of formalization. Governments must have both political will and available budget to honor these formalization incentives and promises.
Most times however, MSMEs distrust governments’ promises and incentives for formalization, and think that, such promises are politically motivated and short-lived with the political office of the ruling government; and that, as soon as there is change in government, such incentives dissipate.
In Morrocco for example, the local government in Marrakech first promised street vendors a reduced tax rate if they registered their businesses. Once they did, the authorities charged the vendors four times higher the promised amount and required them to pay taxes for the past five years retrospectively (Citron, 2004,110).
There are also evidences of extortion by some local authority-officials from MSMEs for issues of non-compliance. Governments promise on formalization incentives must be devoid of political considerations. Also, state agencies tasked with formalization policies must exude trust and professionalism in discharge of their duties, in order to elicit needed trust from these informal MSMEs.
Formalization sensitization is also paramount in this regard. Evidences suggest that, most governments know little about the business dynamics of the informal MSMEs whom they wish to formalize or regularize. In some instances, educated government (tax) officials dislike interacting with the poor, illiterate, and sometimes disenchanted small business owners who are presumed to be antagonistic to tax or license officials.
On the other hand, these MSMEs lack substantial details on formalization and its attendant benefits to them. Information asymmetry thus exist between the governments’ side and the MSMEs. An IFC survey on informal MSMEs in Sierra Leone revealed that, lack of information by MSMEs is single most important deterrent for acquiring business registration or licenses, far ahead of cost and inconvenience as presumed by authorities (FIAS, 2006,40).
In Tanzania, government tax simplification program in 2001 failed to attract the informal sector (for whom it was intended) to formalize their businesses, because the authorities ostensibly did not inform the MSMEs about the new tax regime (USAID,2005,31). A similar study in Kenya concluded that “only a tiny fraction of the jua kali (informal enterprises) know about the myriad schemes and projects designed to assist their business to grow (King,1996, 91).
In fact, information gap on formalization is seen to be far more costly than any other formalization policy and hence must be given needed attention. To overcome this challenge, governmental agencies and officials tasked with formalization policies must embark on mass sensitization and civil education exercises on formalization. They can succeed on this by partnering with local stakeholders such as churches, mosques, identified trade unions, clubs etc.
To succeed, formalization polices (approaches) must not be implemented in silos, but rather in simultaneity with each policy complementing the other. When formalization is properly adopted by MSMEs, sustainable and decent jobs are guaranteed, and governments get the tax bounty.
The writer is a Green SME Expert & SME banking Consultant
Tel: +233 549847220