The Benefits of Formalization: Evidence from Vietnamese Manufacturing SMEs
Introduction
Informality constitutes a growing feature of many developing countries, and notwithstanding its heterogeneity, the informal sector is generally associated with low profits and productivity, limited credit access, the absence of official employment contracts and limited or no social security for workers. The bulk of existing work on informality focuses on its causes, characteristics and consequences, while research devoted to understanding the drivers of official registration and exposing the benefits of formalization is scarcer. This is partly due to a lack of appropriate data, especially on micro (household) firms, which ironically, are precisely the kinds of firms that are most likely to be operating informally. Moreover, in much of the literature, informality is perceived as an involuntary condition brought about by excessive regulation and weaknesses of the legal system (Dabla-Norris, Gradstein, & Inchauste, 2008). However, other recent studies (de Mel et al., 2011, Maloney, 2004) suggest that remaining unofficial is often a conscious choice based on the “degree of attractiveness” of informality versus formality. Thus, efforts to unveil the potential gains associated with formalization could serve to incentivize firms to shift out of informality.
In this paper, we examine the firm level effects of becoming legally registered using two quantitative small and medium enterprise (SME) surveys from Vietnam (conducted in 2007 and 2009), and a smaller ethnographic study conducted in the Hanoi area in 2009. As in many other developing countries informal businesses in Vietnam make up a significant share of the firm population and are major sources of employment.1 Given that the analysis revolves around observing the effects of informal firms shifting to formal status, and that all informal firms are found in the household category, our focus is on firms that were classified as household firms in 2007.2 We define formal firms as those that are registered to pay taxes (have a tax code). The main objective of this paper is to expose the potential benefits of formalization, both for firms and for the workers in these firms. Our paper also contributes to the small number of Vietnam-focused studies on informality, the majority of which are anecdotal and based on case studies or small unrepresentative surveys covering mostly the rural areas (see Cling et al., 2010 for a review).
Controlling for determining factors and observable time-variant factors that may simultaneously influence the decision to formalize and subsequent firm performance our results show that formalization leads to an increase in firm gross profits and investments. Moreover, we find that operating officially leads to an improvement in employment quality as measured by a decrease in the use of casual workers (an increase in the share of workers with formal labor contracts), yet we find no evidence that becoming legal leads to a higher share of wages in total value added.3
The paper is structured as follows: in the subsequent section we provide a selective overview of the existing literature and the motivation for the paper. In Section 3, we describe the data and outline the methodology for the empirical analysis. Section 4 presents the results of the analysis followed by a concluding discussion in Section 5.
Section snippets
Literature review
The existing literature on informality may be broadly divided into studies examining the causes and characteristics of the informal sector, and those focusing more on the outcomes of unofficial activity.4 In terms of the determinants, a large informal sector has been associated with a number of factors, and some of the most cited include: a higher tax
Data and econometric approach
To shed light on the impact of formalization on firm outcomes, we rely on two types of data: (i) an ethnographic study of 10 informal and formal household firms and (ii) a larger quantitative survey designed with a broader focus, covering 10 provinces and following more than 2,500 firms over time.
Profits
As shown in previous studies (Fajnzylber et al., 2011, McKenzie and Sakho, 2010) firm benefits of operating officially include higher profits, better access to credit, increased investments and higher customer demand (due to the ability of formal firms to issue VAT invoices). However, on the downside, formal registration entails certain costs.
Conclusions
This paper has examined the effects of formalization on a number of firm level outcomes in micro, small and medium enterprises in Vietnam, using unique panel data from 2007 to 2009 and covering both formal and informal firms. Our focus is on firms that were classified as household firms in 2007, since all informal firms are found within this category. In order to identify the effects of formalization, we use both a matched double difference approach and an IV strategy to account for the fact
Acknowledgments
John Rand, Institute of Food and Resource Economics, and Nina Torm, Department of Economics, are both employed at the University of Copenhagen. We are grateful for productive and stimulating collaboration with the survey teams from the Vietnamese Institute of Labor Science and Social Affairs (ILSSA) and staff at Central Institute for Economic Management (CIEM). We have also benefitted from a series of comments and suggestions from participants in the 2010 Informal Sector and Informal Employment
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