Supporting Growth to Formalize Enterprises

Approximately two-thirds of the global workforce operates in the informal economy, participating in market activities are not formally registered. This sector is particularly important in low- and middle-income countries, where many microenterprises operate informally in order to survive, representing between 30% and 75% of these economies.

Efforts to formalize these businesses often fail owing to a lack of understanding about why businesses choose to remain informal. Institutional theory helps explain how framework conditions influence business decisions, including business formalization. Formal institutions are explicit codified rules that shape market interactions and are enforced by government authorities (e.g., laws), whereas informal institutions are the norms and values that shape market behavior and are socially accepted among individuals and groups in a given context (e.g., cognitive and moral behaviors).

Recent studies show that formal and informal institutions are interconnected, and institutional congruence (the alignment between formal and informal institutions) affects the number of unregistered firms. The high institutional incongruence in low- and middle-income countries leads to greater informality, which is why policies are needed to reduce this incongruence. Other characteristics, such as business size, also influence formalization decisions. Smaller enterprises are influenced more by informal institutions and are less likely to formalize.

I recently published the article “The formalization of microenterprises in middle-income countries: informal institutions as a mechanism to address institutional incongruence” (Management Research: Journal of the Iberoamerican Academy of Management, 2024), co-authored with Claudio Bravo-Ortega (Adolfo Ibáñez University), Carla Bustamante (IESE Business School), Pablo Egaña del Sol (Adolfo Ibáñez University), and José Sexton (Adolfo Ibáñez University). This study focuses on Chilean microenterprises and reveals that formal institutions do not significantly influence formalization, while informal institutions are crucial, especially for smaller companies. This suggests that, in order to foster economic development and innovation, middle-income countries like Chile need a softer approach to formalization and policies that support microenterprise growth, rather than strict regulatory compliance.

The weakness of formal institutions to explain formalization

Formal institutions – such as laws and property rights – can encourage formalization by creating equal conditions and reducing uncertainty for entrepreneurs. For example, increasing the number of audits has been shown to induce informal businesses to formalize. However, in low- and middle-income countries, aggressive law enforcement strategies can be counterproductive due to complex institutional landscapes.

In these countries, high costs and limited resources to enforce the law can lead to larger informal economies, as well as undesirable consequences such as black markets. Therefore, while formal institutions can promote formalization, their effectiveness depends on the legitimacy of the State, which is usually low in these contexts. Regulators often argue that formalization improves the productivity and economic participation of microenterprises. However, in low- and middle-income countries, formal institutions fail to promote this formalization since these supposed benefits are largely non-existent and social protections are insufficient. Formal institutions alone do not explain the formalization decisions made by entrepreneurs.

The role of informal institutions in (in)formalization

Informal institutions are socially reinforced norms and values that facilitate market interactions, unlike formal institutions, which are codified rules with a top-down approach. In low- and middle-income countries, where formal institutions are often inefficient, informal institutions play a crucial role in legitimizing market activities and offsetting the shortcomings of formal institutions.

In these contexts, entrepreneurs may resist formalization due to barriers such as a lack of investment capital, inadequate infrastructure, and limited legal protections. The social acceptance of informality in these regions leads to low taxation and incongruence between formal and informal institutions. In Latin America, for example, the high dependency of informal institutions can even affect financial organizations.

Our study explores the idea that the scenario in middle-income countries differs from that of low-income countries. While low-income countries may experience an institutional void, in middle-income countries formal institutions are present, but not effectively aligned with informal institutions, leading to market inefficiency. For example, Brazil has well-developed legal and regulatory systems, but social norms often prioritize relationships over formal rules.

While informality saves registration costs, it also comes with challenges related to growth, such as attracting quality talent and operating legitimately. This is why exploring how formal and informal institutions interact is so important to explain formalization processes.

Our findings show that informal institutions can serve as a moral and social “tax,” discouraging informality when business size is relatively large. In other words, as these companies grow, the informal norms that tolerated informality shift, increasing the penalization of informality and pushing larger microenterprises towards formalization.

Consequently, in middle-income countries, informal institutions have a negative impact on business formalization, an effect that is moderated by the size of the companies. Larger firms are more likely to formalize for strategic reasons, while smaller firms may remain informal due to the costs and time associated with formalization.

Our findings challenge the conventional belief that solid formal institutions are the main driver of business formalization in middle-income countries, by demonstrating that they do not significantly influence the decision to formalize microenterprises. In contrast, a business's intention to grow, indicated by sales, plays a more critical role in shaping formalization decisions.

While enforcing laws and establishing clear property rights can foster formalization by reducing uncertainty, our study suggests that a hardline approach through deterrence mechanisms is less effective due to persistent institutional incongruence.

Reevaluating formalization policies

Our study increases the understanding of business formalization, defined as the registration of a business with the appropriate government agencies. Current formalization policies often underestimate the complexity of informal market activities. In this situation, regulators must recognize that simply enforcing them is not enough.

Instead, they should focus on understanding the unique dynamics of low- and middle-income countries (and the differences between the two), where many microenterprises operate informally out of necessity in the face of contexts of inefficient formal institutions and high poverty rates. This is crucial because hard formalization policies can lead to adverse outcomes, such as black markets and an increase in informal demand and even a lower growth of the initiatives of the poorest population groups.

With respect to institutional incongruence, our findings suggest the need to support entrepreneurship effectively. This involves recognizing the potential of entrepreneurship to drive economic growth and development and generate institutional conditions conducive to the creation and growth of new companies. This includes providing incentives, simplified compliance procedures, and educational initiatives. By focusing on business growth, subsistence-based informal microentrepreneurs can transition to the growth-oriented informal sector, eventually leading to formalization in the long run.

Policymakers should recognize that formalization rates in middle-income countries are lower than in high-income economies because citizens feel that the State has failed to provide fair procedures and redistributions. Therefore, policies must be context-specific and address cultural tendencies towards informality, especially in Latin America.

The author is research professor at EGADE Business School and VIVA Idea Schmidheiny Chair in Sustainable Futures.