Low-and lower-middle-income countries typically have a large informal sector, very high self-employment rates and low levels of tax collection. A recent project in Sri Lanka to induce small firms in the informal sector to register did little to change the trajectory of most, but registration did help some firms generate rapid growth – an outcome with important policy implications.
For governments in developing countries, getting firms to register should not be simply a cost-benefit calculation involving a trade-off between enforcement costs and tax collection. Registration can also improve the attitude of small business owners towards the state and, more importantly, help stimulate economic growth.
The tendency of small firms to remain in the informal sector may have an even more pervasive detrimental impact on growth than one might expect. Their informal status usually allows them to avoid taxes by keeping costs and revenues off the books. However, the lack of information arising from production costs, and the basic accounting systems on which they rely, mean many costly errors in pricing can be made, resulting in considerable lost business.
Focusing on avoiding taxes in the informal sector can often distract firms' attention away from important growth opportunities. Although taxes may discourage some economic activity, the problem in low-income countries is typically lack of capacity and under-enforcement, rather than over-taxation.