The informal sector, which is often referred to as the ‘underground economy’, is characterised by the existence of businesses which are not registered. This is mainly due to the inability of most governments to effectively monitor their activities and operations. The International Labour Organization states that as a result of operating in an unregulated environment, a large percentage of informal businesses do not pay taxes, benefits, or entitlements to their workers. This not only locks them out from accessing social protection, but also means that they compete unfairly with other enterprises. The shortfall in tax and contribution payments, which is sometimes very significant given the economies of scale, places an unfair burden on registered businesses. Moreover, when they are deprived of public revenue, governments are limited in their fiscal space and ability to extend social protection schemes and other systems which are vital to national development, such as infrastructure and education and health systems.
Some of the reasons as to why most of these informal businesses do not register include regulatory barriers, taxes, business fees and financial requirements, corruption in public administration amongst other factors. USAID defines regulatory barriers as inappropriate requirements which stem from a government policy-making environment that does not appreciate the need to keep regulatory burdens to a bare minimum in order to place fewer barriers in the way of entrepreneurs. A good example is given in the case of laws governing milk production and sales in Kenya. These are largely drawn from western models and standards. As such, they pose unrealistic requirements such as requiring traders to have fixed premises and insisting on pasteurisation. This ignores the fact that many traders are mobile and that it is household practice in Kenya to boil milk before use. The result is that the small scale traders are forced into informality.
In addition, most business registration and licensing fees are often set at levels that act as a disincentive to businesses to formalise. Most of these informal enterprises would rather choose to avoid paying such fees and instead divert those resources into the operations of their businesses such as paying suppliers and employees’ salaries. Complex tax rules push informal businesses into situations whereby they fear being caught for non-compliance of the rules they have not understood. This makes a vast majority of traders to judge it less risky to avoid the tax system all together, opting to remain informal. Also, corruption among public officials is a key reason as to why most businesses in the underground economy are discouraged from formalising. Informal economy enterprises must still pay bribes to stay in business, but they limit their contact to a small number of officials such as police, and they avoid officials involved in taxation, health, labour regulation and licensing.
Anzetse Were, a leading Development Economist, points out that steps are being taken in the right direction by the Kenya Revenue Authority (KRA) to enhance tax compliance by introducing itax, which makes it easier for individuals and businesses to pay taxes. More can be done to incentivise informal businesses to formalise by offering tax amnesties to informal businesses that register and start the journey towards tax compliance. She adds that the priority should be for the KRA to continue facilitating tax compliance as other arms of government work to support players in the informal sector to become more profitable.
Informal Economy Analyst