Bringing light to the grey economy

IT IS not what Kavita Ahuja, a tutor in Mumbai, does at her job that marks her out from around nine in ten of her fellow Indian workers, but what she does afterwards. As one of her private economics lessons ends, she does not ask her pupil for cash. Rather, her fee of 400 rupees ($6) is settled with a few taps of a smartphone. A side-effect of receiving pay digitally is that she has joined the 48m Indians—in a country of 1.3 billion—who work in the formal, regulated economy. Eduwizards, the app that matches Ms Ahuja to her pupils, deducts what she owes in income tax before paying her, as well as incurring a slew of taxes on its cut.

Moving from the informal to the formal economy can be that simple. But in many countries the transition remains rare. Half to three-quarters of all non-agricultural workers in poorer countries (perhaps 2 billion people) fall outside the purview of officialdom and so can be categorised as “informal” (or “shadow” or “grey”). In rich countries the share is much smaller, though still significant. One-tenth of Britain’s economy is thought to be informal.

Informal businesses typically sell legal goods and services. They include everyone from Italian restaurateurs who do not issue receipts, Ukraine’s ubiquitous street vendors selling fruit and vegetables and Indian households who pay their servants cash-in-hand. World Bank data suggest that informality is expanding. Over the past decade the world’s working-age population has been growing faster than the number of people officially employed, implying that there are more and more people in jobs outside the mainstream.

Is that so bad? Informal workers might otherwise have no job and even harder lives. When famine struck North Korea in the 1990s, millions broke the law by selling smuggled food. Plucky entrepreneurs who operate beyond the grasp of venal bureaucrats should surely be celebrated. Robert Neuwirth, an author, refers to Lagos’s largest rubbish dump as a “business incubator”, such is the enterprise that flourishes there. Much informal activity is also tolerated in practice. Nobody expects teenagers with the odd baby-sitting gig to set up limited companies with audited accounts.

But large-scale informality has malign effects. A paper from Friedrich Schneider of Johannes Kepler University in Linz, Austria, suggests that the tax loss from informality in the European Union was about €450 billion in 2011, or 4% of GDP—money the region’s indebted governments would find handy. And if every country in the world reduced its informal economy by 10% of GDP, back-of-the-envelope calculations suggest that they would garner $1 trillion or so extra in tax each year. For comparison, economists reckon that roughly $200 billion of tax is lost each year because of crafty use of tax havens.

Informal workers also get a bad deal. They earn no pension and may be paid on average half as much as formal employees. Wages are low in part because informal firms are less productive than formal ones. They are also smaller—expanding can mean catching the eye of officialdom and is hard to do without bank loans, which require proper book-keeping. In poor countries the average formal firm employs 126 people, compared with just four for informal ones, according to Rafael La Porta of Tuck School of Business at Dartmouth and Andrei Shleifer of Harvard University.

Beware of the dark

For years the received wisdom was that the remedy for informality was development. As countries become richer, so the theory went, formal sectors grow and those where informality reigns, such as street-vending, shrink. But that is a slow process, and it is made slower by informality itself. Whatever cash an informal firm generates sits outside the financial system, making it harder to invest in other businesses.

Governments have come to realise that they need to do something about informality. One approach is to cut bureaucracy. Many countries aim to make registering a firm a breeze—not least to improve their rankings in the World Bank’s closely watched annual ease-of-doing-business index. Someone in Burkina Faso now needs to complete just three steps to start a business, fewer than in Norway and down from 12 a decade ago. Making it easy to pay tax matters, too. Nevertheless small businesses often fear that coming out of the shadows will mean more shakedowns by corrupt officials, or being entangled in reams of red tape. Research suggests that in practice, streamlining registration has little effect on informal firms that already exist.

The next generation of businesses, however, might find informality much harder. Firms that deal in cash have an incentive to underreport their income or employ staff informally. About 84% of all consumer transactions worldwide are still cash-based, according to MasterCard, a credit-card provider. But that share will fall as more workers ply their trades on digital platforms, whether tutors on Eduwizards or drivers on Uber, a ride-hailing app. About half the world’s adults now own a smartphone; by 2020 80% will.

Digital platforms allow electronic payments, which are easy for tax authorities to track. When taxi drivers in Brussels complained that Uber used elaborate tax-avoidance methods, Belgium’s deputy premier retorted that the average Brussels cabbie declared an implausibly low €25 ($28) of cash income a day. Who exactly was doing the tax dodging? Most e-commerce is formal: as it grows, it displaces at least some economic activity that is not.

And it is possible to accelerate the transition away from cash, making outliers of those who use it. South Korea drove down the share of coins-and-notes transactions from 40% to 25% between 2002 and 2006 by applying a lower sales-tax rate to card payments. An effective payments infrastructure (for example, free and fast transfers between bank accounts) also helps. A number of countries have banned cash for transactions above a certain threshold. Italians are lovers of cash. Many were furious when a cap on cash payments over €1,000 was introduced in 2011. Partly in response to the outcry, Matteo Renzi, Italy’s prime minister, last year raised it to €3,000. In Sweden and other parts of northern Europe, by contrast, paper money is becoming a rarity. Many shops and even bars refuse to accept the folding stuff, and cash machines are hard to find.

In countries where cash is king, forcing people to record transactions makes it harder to evade tax. Receipts are the norm in business-to-business transactions, especially if value-added taxes (VAT) are applied. An entrepreneur can deduct input costs from profits that are liable to be taxed—an artist can claim for the cost of papers and pencils, for instance. But he must prove he paid for those supplies. This prompts the artist’s suppliers to be formal, and their suppliers too. A desire to increase formalisation is one reason why India is implementing a nationwide VAT.

Consumers have much less incentive to ask for receipts, particularly for small-value transactions. Italian restaurateurs know that few customers will protest if they give them a receipt scrawled on the back of a napkin (a wheeze that allows them to avoid declaring the transaction). Even the spread of credit cards does not guarantee improvement: restaurant owners and shopkeepers often turn up the palms of their hands as they tell you that “purtroppo” the card machine is broken. Sicilians are so bad at paying their taxes that around Catania the guardia di finanza (finance police), a branch of the armed forces, are a noticeable presence.

The problem of the panopticon

Forcing informal firms out of the shadows carries one big risk. A recently formalised firm may struggle to survive if regulations are burdensome. If a boss must pay high payroll taxes or pension contributions for his workers, he may have to employ fewer people. South Africa has cracked down on its informal economy, but it is a Pyrrhic victory. Formal jobs have not filled the gap; half of its young people are unemployed.

Governments therefore need to reduce the burden of taxation and regulation on business. The Baltic states have low business taxes, especially on small firms, alongside crafty formalisation schemes. They have seen large drops in informality compared with other OECD countries in the past decade. Compare that with Italy, where a growing tax burden means that its informal economy, relative to GDP, is now 50% larger than it was in the 1970s.

Grand reforms are important. But there are also wheezes that will nudge citizens to behave better. For example some countries have tried to encourage consumers to ask for receipts. Several have enacted “receipt lotteries”, where proofs of payment become de facto lottery tickets. Taiwan’s dates back to the 1950s. European countries such as Portugal, Poland and Slovakia (where prizes include the chance to appear on the local version of “The Price is Right”) introduced them in the aftermath of the financial crisis.

The lotteries’ proponents say that their aim is to entice shoppers and vendors to register activity. Technology can help there too. Since 2007 shoppers in São Paulo have received lottery tickets and rebates on the VAT applicable to their purchases if they can match them against receipts. Better yet, the database of receipts they submit digitally can be cross-checked against the income that businesses have declared. Joana Naritomi at the London School of Economics estimates that revenues declared by paulistano shopkeepers jumped by over 20% in four years as a result.

Cross-checking of different sources of information is a smart way to compel people to pay tax, says Ms Naritomi. That too is becoming easier. Matching a firm’s pay slips with its employees’ tax returns used to take an age; a computer can now do it quickly. In Italy, comparing aerial images with land-registry maps identified 2m “ghost buildings” that authorities were unaware of—and thus not levying property taxes on. Inhabitants of southern Italy were the most egregious violators.

Technology can also make formality attractive by enabling registered firms to get more out of it than a tax bill. For many, that means access to credit. Lots of startups are using digital records, from phone bills to app payments, to gauge a potential borrower’s ability to repay. Such data are generated, by and large, only by those willing to play by the rules. “If people get access to credit they are willing to pay taxes,” notes Nandan Nilekani, a former boss of Infosys, an IT services firm, who went on to advise the Indian government.

Combining structural reform, clever wheezes and technology to curb informality would be good for government finances, growth and poverty reduction. No economy will get rid of informality entirely, but bringing some unregulated activity out of the darkness would improve millions of lives.