Omnipresent informality in economy is costing national exchequer dearly
Informality in economies is a reality of our existence. The concern, however, is its extent. Different studies by the Asian Development Bank (ADB) and the World Bank have estimated that about 38 percent of Nepal’s economy is operating in the informal sector. This figure is about 23 percent for India, 35 percent for Bangladesh and 11 percent for Japan. The Asian average has been estimated to be about 26 percent.
Because of its hidden nature, it is difficult to define informality. It is often mixed, comprising of both legal and illegal activities. The World Bank has defined informal economy as ‘legal economic activities taking place below the radar of the government’. To put it simply, informal economies are those economic activities which are conducted by avoiding government rules, reach, and taxes.
In their study of 162 economies around the world, economists Friedrich Schneider, Andreas Buehn and Claudio Montenegro have concluded that informal economy exists deliberately and is concealed from public authorities for the following reasons. One, to avoid payment of income tax, value added or other taxes. Two, to avoid payments of social security contributions. Three, to avoid meeting certain legal labor market standards, such as minimum wages, maximum working hours, safety standard. Four, to avoid complying with certain administrative procedures, such as completing statistical questionnaires or other administrative forms.
Informality in Nepal’s economy is omnipresent. Informal transactions can be found in small enterprises as well as in large firms. This takes place as both under reporting of the businesses and/or not reporting them at all. The local tea stall, barber shop, vegetable vendors, food stores, taxi drivers, construction workers , and many other small firms and self employed business––that are sources for informal employment for lower / lower middle class and rural population––are rarely registered anywhere. Though such businesses look small individually, collectively, they occupy a big portion of the informality pie.
A fresh study by Nepal Rastra Bank has revealed that about 30 percent national economic activity is concentrated in Kathmandu, and that the residents of Kathmandu valley alone spend about 68 percent of their income to pay house rents. But the compliance level of house rent tax is extremely low, with an annual nationwide collection of just over Rs 1.5 billion. There is massive informality in this sphere as well.
Let’s take one more example of informality, which stems from imports. The customs declaration for most of the imported goods is significantly lower than the actual price and they are under-valued at customs points. Escaping and hiding from all layers of transactions, the chain of under reporting extends even to the retail level. To hide the true transaction, firms either do not issue any invoice or raise fake invoices. Last year’s fake VAT bill scam is a glaring example of such tendency.
In Nepal, it is an open secret that registered firms maintain three types of accounts. One for banks, in order to take loans, which is over estimated. One for the tax office, which is substantially under reported to avoid paying taxes. The last one reveals the real picture, which is for their own purpose, and is never disclosed to others.
REASONS BEHIND INFORMALITY
Informality arises when the incentive for not registering is higher than the incentive for registering. Economists, Oviedo, Thomas and Karakurum-Ozdemir (2009), have presented about a dozen reasons for informal activities. They include burdensome regulations (high entry costs, strict labor regulations, high taxes, complicated procedures), low human capital, high economic inequality, poor quality of public services (infrastructure, social protection), lack of access to resources (land credit and so on) and slack monitoring and enforcement.
The lack of trust between state institutions and entrepreneurs is one of the major reasons behind informal activities in Nepal’s economy. There is a trust deficit between tax payers and tax offices as well. Weakness in the implementation of laws, lack of efficiency and transparency in service delivery, heavy costs associated with registration processes and the absence of a global social security or a pension system are some of the other reasons why firms prefer to operate in the informal sector.
The other fundamental cause is that Nepal is a cash-based economy. Cash transactions are easier to hide from regulatory agencies. When there is no system of recording payments and receipts, it provides safe havens for informality.
There are many costs of having an informal economy and the loss of tax revenue is the most glaring one. The large size of informality (about 38 percent of GDP), means a significant loss in tax revenue, which is too dear for a country like Nepal, where the current tax-GDP ratio is just over 13 percent. Even if we were able to bring half of it into the formal sector, the revenue yield would be significantly higher.
The economic costs stemming from informality are alarming at the level of firms as well. Businesses in the informal sector are mostly fragmented and small scale, thus, failing to reap benefits of economies of scale. They are short of credits from formal channels, and thus have limited capacity to invest and innovate. Workers in the informal sector are mostly low skilled, with low levels of education, training, and entrepreneurship.
Though the informal sector can help save entrepreneurs money by avoiding taxes, there certainly are significant hidden costs of remaining in the informal sector. It ends up as a zero sum game. Externalities like the free rider problem also put pressure on the pool of common resources. Further, researchers have also found a significant negative relationship between informality and growth. Higher informality results in slower economic growth.
Reversing the reasons of informality would be a good way to begin restricting the phenomenon. Policy reform that facilitates the formalization process, and provides incentives for registration in the formal sector should be the starting point. The cost of registration should be kept lower than the cost of non-registration. Smooth flow of information between state and economic actors is critical too. Tax compliance could be enhanced through simplified tax rules, minimizing compliance cost and effective enforcement.
ECONOMICS OF INFORMALITY
Also, steps need to be taken to rationalize the cash-based economy. A cash economy always provides opportunities for tax evasion, money laundering and for other economic offenses.
At a time when the country is in acute need of resources for constructing a new Nepal, concerted actions are needed urgently to downsize the expanding informal sector. This is imperative not just to enhance tax revenues, but also to create a growth friendly economy.
The author is deputy director general, Inland Revenue Department. Views are strictly personal