Formalising the Informal Sector

The informal sector consists of businesses whose operation falls outside of official government parameters for a number of reasons. This puts these entities at a disadvantage as they are often excluded from the benefits that come with formalisation. In this sense, they do not have access to vital support systems that cushion them from the shocks encountered while running a business. Efforts geared towards tackling informality have often been focused on looking for ways through which these businesses can be formalised. There are issues that have to be considered for this to be effectively achieved. Peruvian economist Hernando de Soto is of the view that many people join the informal economy because the red tape alongside the bribes that go with it, virtually make it impossible for them to operate legally.

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One disadvantage of having a large informal sector is that it deprives governments of crucial revenue for most businesses in this portion of the economy do not pay taxes. Anzetse Were, a Kenyan development economist, is of the view that there are a couple of barriers that hinder the transition into formality which fall into two categories. The first is the expense of transition whereby business registration and licencing processes are laborious processes. The other is the fact that formality is linked to expensive compliance requirements such as complying to inspection standards, paying high wages and taxation. A clear case has yet to be made to informal businesses to convince them of the benefits they would accrue from formalising and entering the tax net.

In the quest to formalise informal businesses, there are factors that should be taken into consideration as well as a process that can be followed that will ensure sustainable business entities are developed. Some of the systems that need to be put in place revolve around strengthening operational capacity, productivity and profitability, legal support and lastly financing and mentoring.

In as far as strengthening the operational capacity of informal businesses goes, interventions should focus on training that is aimed at streamlining internal operations such as maintaining and updating business records, upgrading of skills and developing strategic business plans that demonstrate clear expansion strategies. Proper business records place these businesses in a better negotiation space when approaching financial institutions for collateral to expand their operations. Skills upgrading will enable informal enterprises to enhance the quality of their products and services by ensuring that products are uniform and standardised while the services are up to date and conform to industry expectations.

Working on improving the productivity and profitability component entails looking at factors such as access to skilled labour as well as a focus on marketing. Informal enterprises find it hard to attract and maintain high skilled labour due to their financial position, which negatively impacts their productivity. This is not the case for larger formal enterprises for they are better financially placed to attract this resource and can hence fully exploit economies of scale, thus enhancing their profitability.

The issues around legal support involve matters to do with conformity to labour laws and taxation rules in accordance with the law. Informal businesses need professional support when configuring their internal operational systems. They require guidance in this area so as to ensure that they fully understand labour law and taxation requirements. This will equip them with the information they need when interacting with the authorities that implement these laws, thus reducing incidences where they are extorted due to ignorance.

Last but not least is the component of financing and mentoring. Most informal businesses find it challenging to access funds to upscale their operations. Most financial institutions turn them away due to their high-risk nature. The most suitable approach to be used when thinking of financing these businesses should consider offering affordable and patient finance models. This can be in the form of interest free loans, concessional loans and grants. It is key to couple such interventions with mentoring programs with formal businesses in a process that equips the informal enterprises with the necessary experience and expertise.

It is vital to ensure that the aforementioned basic components are taken into consideration by policy makers when they consider employing interventions that are aimed at supporting informal businesses in a way that enables them to formalise. There is much more that can be done to ease this process which includes offering incentives to encourage formalisation such as offering introductory or subsidised tax rates for newly registered businesses. These will however need to be thoroughly thought through to minimise loopholes that can be taken advantage of by scrupulous businesses.

litualex@gmail.com

Informal Economy Analyst  

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Impact Investing in Informal Enterprises

Impact investments are investments made into companies, organizations and funds with the intention to generate social and environmental impact alongside a financial return. The Global Impact Investment Network (GIIN) states that this sort of investment provides capital to address the world’s pressing challenges in sectors such as microfinance, sustainable agriculture, renewable energy, conservation and affordable and accessible basic services such as housing, healthcare and education. The aspect of this form of investment that makes it stand out from other vehicles of investment is the fact that it is aimed at generating positive impact beyond financial return. In this sense, it is a viable solution to the sustainable growth and development of micro, small and medium sized enterprises. It is a tool that can be used to provide patient capital to entrepreneurs, more so if it is blended with grants.

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A study that was conducted in West Africa by Dalberg found that impact investments are primarily made by private equity and venture capital funds, Development Finance Institutions (DFIs), Micro Finance Institutions (MFIs), foundations and institutional investors. “Impact investing in West Africa” noted that the needs of individual enterprises varied depending on factors such as their business model, size and maturity stage as well as human resource capacity. Beyond financing needs, many enterprises require business development services in a way that enables them to develop their ideas and create well managed, financially sustainable operations.

Some of the challenges that stand in the way of achieving the goal of developing sustainable business ventures in as far as engagement with impact investing is concerned include a lack of education, skills and difficulty in accessing information among the entrepreneurs that are required to turn their ideas into bankable projects. Also, the lack of awareness of the actual implications of engaging impact investors prevents many businesses from accepting this type of capital. This is due to the fact that owners of small and medium sized enterprises fear losing control of their businesses. Further, the study noted that the lack of incentives to convert from informal to formal business structures was a hindrance for impact investors in as far as engaging the informal sector in West Africa goes. The high costs that are linked to business formalization which include licences, taxes and other operating costs discourage most informal businesses from making the transition to formality.

The report put forward some ways in which the above challenges can be mitigated for an enhanced and more proactive engagement with impact investment. These include the need for a broader range of flexible products to address the gap for businesses with smaller financing needs. This is particularly necessary for new enterprises where the entrepreneurs’ funding needs are too small for traditional debt or equity financing. In this sense, they propose angel financing or royalty-based debt with manageable levels of interest as well as supporting business development services.

The other solution highlights the need for investors to adapt their investment practices to the local climate. By being more flexible in this manner, they will be in a better position to change their investment criteria, thus opening up their business to a large number of potentially profitable deals. This will also place local entrepreneurs in a position where they can access much needed capital to enhance their business ventures. This sort of engagement will support the growth of informal businesses to formal businesses and further assist them to transition into larger private equity and traditional commercial bank investments.

Last but not least is the proposal to build networks and awareness beyond impact investors to encompass business support organisations, relevant government bodies and development partners with the intention of increasing awareness of existing definitions of impact investing. Other goals of these networks should be to increase the awareness of the benefits of venture philanthropy among grant-making organizations, increase the understanding of equity investments among business owners and focus outreach efforts towards high net worth individuals and highly-educated Africans in the diaspora.

litualex@gmail.com

Informal Economy Analyst