Introduction
Report No. 43737-PE
PERU
Trajectories towards Formality
JUNE 16, 2008
Poverty Reduction and Economic Management
Bolivia, Ecuador, Peru and Venezuela Country Management Unit
Latin America and the Caribbean Region
Document of the World Bank
Republic of Peru Fiscal Year
January 1 to December 31
Currency Equivalents
|CURRENCY UNIT |= |Soles |
|1 US Dollar |= |S/. 2.85 |
Weights and Measures
METRIC SYSTEM
Abbreviations and Acronyms
AAA Analytical and Advisory Activities
BCRP Central Reserve Bank of Peru (Banco Central de Reserva del Perú)
BONOPYME Training and technical assistance vouchers
CIT Corporate Income Tax
CNC National Competitiveness Council (advisory body to the PCM)
COFIDE Development Financial Corporation (Corporación Financiera de Desarrollo SA)
COFOPRI Comission to Formalize Informal Property (Comisión de Formalización de la Propiedad Informal)
CONFIEP Peruvian Private Business Association (Confederación Nacional de Instituciones Empresariales Privadas)
CONSUCODE Council of State Procurement (Consejo Superior de Contrataciones y Adquisiciones del Estado)
CTS Compensation for time in service (compensación por tiempo de servicio)
DNMYPE National Directorate for Micro and Small Companies (Dirección Nacional de la Micro y Pequeña Empresa)
ENAHO National Household Survey (Encuesta Nacional de Hogares)
FIAS Foreign Investment Advisory Service
GDP Gross Domestic Product
GOP Government of Peru
GNP Gross National Product
ICA Investment Climate Assessment
IDB Inter-American Development Bank
IFC International Finance Corporation
IGV General sales tax (Impuesto General a las Ventas)
ILO International Labor Organization
IMF International Monetary Fund
INDECOPI National Institute for Consumer and Intellectual Property Defense
INEI National Statistics Institute (Instituto Nacional de Estadística e Informática)
LAC Latin America and Caribbean Region
MSEs Micro and Small Enterprises
MEF Ministry of Economy and Finance
METR Marginal Effective Tax Rate
MTPE Ministry of Labor and Employment Promotion (Ministerio del Trabajo y Promoción del Empleo)
MYPEs Micro and Small Enterprises (Micro y Pequeñas Empresas)
NRS National Registry of Suppliers to the State (Registro Nacional de Proveedores)
OLS Ordinary Least Squares
PCM Office of the Prime Minister (Presidencia del Consejo de Ministros)
PRODAME Self-Employment and Micro enterprise Promotion Program (Programa de Autoempleo y Microempresa)
PRODUCE Ministry of Production (Ministerio de la Producción)
PROMPEX Export Promotion Agency (Comisión para la Promoción de Exportaciones)
PROMPYME Comission for Promotion of the Small and Micro Enterprise (Comisión para la Promoción de la Pequeña y Micro Empresa)
RER Special Tax Regime (Régimen Especial de la Renta)
RUC Tax identification Lumber (Registro Único de Contribuyente)
RUS Simplified Single Regime (Régimen Unico
Simplificado)
SBS Superintendency of Bank and Insurance (Superintendencia de Banca y Seguros)
SMEs Small and Medium Enterprises
SUNARP National Registry (Superintendencia Nacional de
Registros Públicos)
SUNAT Government Tax Agency (Superintendencia
Nacional de Administración Tributaria)
UIT Income Tax Unit
VAT Value Added Tax
|Vice President, LCR: Pamela Cox |
|Director, LCC6C: C. Felipe Jaramillo |
|Director, LCSPR: Marcelo Giugale |
|Sector Director, LCSPE: Rodrigo Chaves |
|Sector Leader, LCSPE: Carlos Silva-Jauregui |
|Task Team Leader: Oscar Calvo-Gonzalez / |
|Rossana Polastri |
ACKNOWLEDGMENTS
This report was prepared by a team led by Oscar Calvo-Gonzalez (LCSPE) and Rossana Polastri (Senior Country Economist, LCSPE) under the overall supervision and guidance of Rodrigo Chaves (Sector Manager, LCSPE) and Carlos Siva-Jauregui (Lead Economist and Sector Leader, LCSPR). C. Felipe Jaramillo (Country Director, LCC6C) linked the team to the Bank’s overall strategy and steered them in that direction. Mauricio Carrizosa (Adviser, IEGCR) and Vicente Fretes-Cibils (IDB) provided initial guidance on the study.
The team also included Luis Barrantes (LCSPE), Sebastian James (CICRS), Jan Loeprick (CICKM), David McKenzie (Senior Economist, DECRG), Rashmi Shankar (LCSPE), and Rich Stern (Program Coordinator for Business Taxation, FIAS). Contributions were also received from Cesar Baldeon (CFOMR) and Gladys Triveño (Proexpansión). Ipsos APOYO Opinión y Mercado conducted the survey of micro and small businesses and CONECTA carried out the focus groups and in-depth interviews with micro and small entrepreneurs. Maria Ines Thorne provided valuable logistical and production support.
The peer reviewers for the report were Alvaro Escribano (Universidad Carlos III), Pablo Fajnzylber (Senior Economist, LCRCE), Luke Haggarty (General Manager, CLALA), Vincent Palmade (Lead Economist, AFTFP), and Jamele Rigolini (Economist, EASHD). The report also benefited from substantive comments from a variety of people during various stages of this project, including Jacqueline Coolidge (Lead Policy Investment Officer, CICAF), Gladys Lopez-Acevedo (Senior Economist, LCSPP), Juan Carlos Mendoza (Senior Financial Economist, LCSPF), and Ian Walker (Lead Social Protection Specialist, LCSHS).
The team received valuable guidance through meetings with various authorities. Important insights and contributions were gained through interviews with a wide variety of individuals and groups representing officials of the Peruvian Government, institutions, and private sector (micro and small) firms. Particular thanks to the entrepreneurs who generously granted us their time through numerous interviews. The team would like to thank the Peruvian authorities for their continued cooperation, especially the support of the Ministry of Economy and Finance (MEF), the Ministry of Labor (MTPE), the Ministry of Production (PRODUCE), the National Institute of Statistics (INEI), the Superintendence of Tax Administration (SUNAT), the Superintendence of Banks and Insurance (SBS), the National Council of Competitiveness (CNC), and the Central Bank of Reserve (BCRP).
Trajectories towards Formality in Peru
Table of contents
Executive summary and policy implications 9
1. Introduction 19
Informality in the sectors selected for the survey 26
2. Determinants of informality 31
A. Who is our source of information? 32
B. What do micro and small business owners tell us? 35
C. Econometric analysis of the determinants of informality 61
D. Dynamics out of informality 65
3. The impact of informality 69
A. Is informality a cause of low profitability? 69
B. What is the impact of informality on access to credit? 73
List of references 78
Annex A. Measures of informality based on the ENAHO using different definitions 80
Annex B. Econometric results on the choice of tax regime and determinants of tax inspections 98
Annex C. Econometric results on the determinants of informality 103
Annex D. The impact of informality – methodology and impact on profits and on access to credit 104
Annex E. Trajectories towards formality 114
Annex F. Database of sector-specific labor regulations - methodology 115
Annex G. The Marginal Effective Tax Rate Methodology 116
Annex H. Data for calculating the marginal effective tax rate 125
List of boxes
Box 1: What do we mean by informality? 19
Box 2: A dedicated survey to study informality in Peru 24
Box 3: Understanding the incentives of tax regimes – the Marginal Effective Tax Rate of the different corporate income tax regimes in Peru 44
Box 4: What do businesses know about the Special Labor Regime for micro firms? 51
Box 5: Severance payments de jure and de facto 56
Box 6: Sector-specific labor regulations and the prevalence of informality 58
Box 7: Case studies – formality is also a ‘refuge’ 65
List of tables
Table 1.1: Measures of informality based on the household survey in the sectors selected for the survey and in the economy 26
Table 2.1: Number of businesses surveyed 32
Table 2.2: Selected informality characteristics of surveyed businesses 33
Table 2.3: Benefits and costs of formalizing perceived by micro and small business owners 35
Table 2.4: Reasons for not having a municipal license 39
Table 2.5: Overview of corporate income taxation 41
Table 2.6: Results from econometric analyses of the choice of tax regime 47
Table 2.7: Definitions of micro and small enterprises in the labor code and correspondence with tax regulations 48
Table 2.8: Business owners’ estimates of how common is for workers to earn less than the minimum wage and not being on the payroll 54
Table 2.9: Reasons for self-employment 56
Table 2.10: Variables that help predict having a municipal license and an RUC number 62
Table 2.11: Variables that help predict having both a municipal license and an RUC number 63
Table 2.12: Summary of steps towards formalization 67
Table 3.1: Impact of different formality characteristics on firm profits 72
Table A.1: Special fiscal regimens for small taxpayers in Latin America 88
Table A.2: Regulatory labor burden in comparative perspective 88
Table A.3: Main informality characteristics among surveyed businesses, by city 89
Table A.4: Main informality characteristics among surveyed businesses, by sector 89
Table A.5: Most important problem affecting micro and business owners 90
Table A.6: Obstacles for micro and small businesses - detailed questionnaire 91
Table A.7: Sales of micro and small businesses surveyed, by customer type and business size 92
Table A.8: Elements of formality 92
Table A.9: Factors affecting the choice of tax regime 93
Table A.10: Participation in state-supported programs 94
Table A.11: Key factors behind the decision not to have a license, by business size 95
Table A.12: Knowledge of where to formalize 95
Table A.13: Share of workers earning less than minimum wage, by business size 96
Table A.14: Reasons for not paying the minimum wage, by business size 96
Table A.15: Percent of workers not on the payroll, by business size 97
Table A.16: Reasons for not having workers on payroll, by business size 97
Table B.1: Choice of tax regime - probit regression 98
Table B.2: Choice of tax regime - multinomial logit (general regime) 99
Table B.3: Choice of tax regime - multinomial logit (RUS) 100
Table B.4: Choice of tax regime - multinomial logit (RER) 101
Table B.5: Probit regression on the determinants of tax inspections 102
Table D.1: "Impact" of having an RUC on log profits 105
Table D.2: "Impact" of having a municipal license on log profits 106
Table D.3: OLS Regression of log profits on both municipal license and an RUC number 107
Table D.4: Businesses with and without bank accounts 108
Table D.5: Sources of finance among businesses that have borrowed in 2007 or 2006 108
Table D.6: Use of credit to purchase inputs 109
Table D.7: Sources of start-up capital 110
Table D.8: Borrowing by sector 110
Table D.9: Sources of finance for most recent loan 111
Table D.10: Terms of loan (annual or monthly rates) by source of finance 111
Table D.11: Average length of loan in months 112
Table D.12: Home ownership - percent of entrepreneur owning their home 112
Table D.13: Business taking credit cards and checks, percent 112
Table D.14: Impact on getting a loan of having a license and RUC number 113
Table E.1: Time lapsed from opening business to getting RUC number and municipal license 114
List of figures
Figure 1.1: Informality in Peru and other countries in Latin America and the Caribbean 21
Figure 1.2: Informality by firm size, selected sectors and economy-wide 27
Figure 1.3: Map of informality prevalence by region 28
Figure 1.4: Informality prevalence by region and income per capita 29
Figure 1.5: Informality rate and economic growth, 2003 to 2006 30
Figure 2.1: Share of surveyed businesses at different degrees of formality 34
Figure 2.2: Benefits from having a municipal license and reasons not to have one 38
Figure 2.3: Benefits from having an RUC number and reasons not to have one 40
Figure 2.4: Distribution by turnover of businesses filing under different tax regimes 43
Figure 2.5: Relationship between the number of workers and those with health coverage and pension 50
Figure 2.6: Kernel distributions of monthly income for private salaried workers – Metropolitan Lima 53
Figure 2.7: Minimum wage in Peru and selected countries in the region 53
Figure 2.8: Informality prevalence for workers, by pay system (piece-rate or not) 55
Figure 2.9: Formality characteristics among surveyed businesses, by age of business 68
Figure 3.1: Difference in profitability between the business with a municipal license and those without 70
Figure 3.2: Difference in profitability between the business with an RUC number and those without 71
Figure 3.3: Financial depth 73
Figure A.1: Calculating the productive definition of informality based on the ENAHO 80
Figure A.2: Map of informality prevalence by region 81
Figure A.3: Map of informality prevalence by region 82
Figure A.4: Map of informality prevalence by region 83
Figure A.5: Informality prevalence by region and income per capita 84
Figure A.6: Informality prevalence by region and income per capita 85
Figure A.7: Informality prevalence by region and income per capita 86
Figure A.8: Informality rate and economic growth, 2003 to 2006 86
Figure A.9: Informality rate and economic growth, 2003 to 2006 87
Figure A.10: Informality rate and economic growth, 2003 to 2006 87
Executive summary and policy implications
Context
1. Informality in Peru is high compared to other countries in the Latin America and the Caribbean region. Measuring informality is notoriously difficult, in large part because informality is not easily defined. Alternative measures of informality include a so-called ‘productive’ definition focused on the characteristics of the productive unit and a ‘legalistic’ definition focused on the coverage of workers by mandated social protection. According to the so-called productive definition of informality, 76 percent of the economically active population in Peru is informal (the third highest share in the Latin America and the Caribbean region). Taking the legalistic definition of informality, around 86 percent of the economically active population lack access to a pension, 86 percent work without a contract, and 80 percent lack healthcare insurance. Peru reports the third-highest rate of informality in Latin America and the Caribbean as measured by the percent of workers without a contract and without health insurance, while Peru is in the middle of the table in the region with regard to access to a pension.
2. Addressing informality is a priority in the policy agenda of the Government of Peru. The Peruvian economy has enjoyed a relatively long period of stable and sustained growth. Poverty numbers are coming down and formal employment is picking up. However, informality is still prevalent and this raises questions about the sustainability of growth in the medium term. The country is investing efforts in access to larger markets through trade agreements and if micro and small firms find it difficult to remain formal due to an onerous state, little can be expected for them in this context. More broadly, informality means that most people are not covered by labor protections. Without a pension, the living standards in old age of many Peruvians are at risk. Without health insurance workers face significant risks to their livelihoods. President García himself referred in April 2008 to informality as the “slavery of the twenty-first century.” But informality also erodes the social contract between the population and the state, making the provision of public services more difficult by reducing the available revenue base. In addition, informality may have a negative impact on business performance – though the cross-country evidence is mixed. It is in this context that the Government of Peru has set the goal of reducing informality by one-third by 2011.
3. This study is timely, as the authorities’ interest in analyses of informality has increased. This report is the outcome of very close cooperation with the authorities of the Government of Peru. The authorities have been involved in all stages of the process, going back to the first phase of this programmatic study. The authorities proved instrumental in helping design the focus of this report, including the scope of a survey of businesses conducted for this study, the survey questionnaire itself, they also suggested specific topics to be explored – which are presented throughout the report mainly in the form of boxes.
4. ‘Formality’ is better understood as having different dimensions. In this report we explore four of those dimensions: business licensing, tax, labor relations and pensions, and business incorporation. It is well known that informality is not a straightforward concept. As a result, it is not easy to agree on a single definition of informality or to measure it easily. The important conclusion to draw from this is that informality can be better understood as being a multi-dimensional concept. In this report we take a pragmatic approach by exploring four dimensions of ‘formality’: business licensing, tax, labor relations and pensions, and business incorporation. Of course, a business person can legally operate with only service providers and no employees; or as a natural person and not a business with a separate legal entity. However, the choice of these aspects of what ‘formality’ may be stems from the result of focus groups with micro and small business owners – these are the very issues they have in mind when they think of ‘formality.’
5. This report focuses on the trajectories towards formality of micro and small businesses, drawing insight by polling those businesses directly. For the purpose of this report, micro businesses are those with up to 10 workers and small businesses those with 11 to 50 workers. This working definition is a practical choice that also reflects the criteria regarding maximum number of workers in the existing Peruvian legislation. It also helped us to design a dedicated survey of 802 micro and small businesses conducted for this study. Informality is widespread across all sectors of the economy and affects all types of firms but it is particularly high among small businesses. Drawing from the day-to-day experiences of micro and small businesses is at the core of this report. The analysis adds value to the authorities’ information set by presenting new evidence on what are the most critical steps in the formalization process and what are the key considerations at those junctures. By focusing on practices and decision-making of businesses, this report complements the analysis of labor market and labor legislation that was a key part of the first phase of the programmatic study.
6. Informality represents not only the exclusion of many workers but also reflects a decision by economic agents to exit the formal sphere. The approach followed here is informed by the analytical work for the World Bank’s Informality. Exit and Exclusion flagship report of the Latin American and Caribbean Vice-Presidency of the World Bank in 2007. In particular, this approach recognizes that informality not only undermines the social contract but is also a consequence of the limited value for the population of the services provided by the state. In other words, informality results also from decisions of economic agents about the optimal level of engagement with the state. Micro and small entrepreneurs use implicit cost-benefit analysis as to whether to remain informal or to formalize. Digging deeper into those choices and cost-benefit considerations is the subject of this report.
Main findings
The study finds no significant impact of certain characteristics of formality, such as having a municipal license or being registered with the tax authorities, on the profitability of businesses or on their probability of obtaining a loan. These results must be accompanied, however, by the caveat that establishing the impact of informality econometrically is notoriously difficult. The methodology used in this report does not attempt to capture the negative effects that informality may have on the performance of formal firms, or the effects that informality may have in undermining social trust and the overall business environment.
The study also finds informality to be particularly persistent in the area of labor relations and access to pension, driven largely by high costs of being formal, limited enforcement of labor relations, and a preference for flexible labor relations.
These two findings combined suggest that: (i) efforts to increase the access to health insurance and pension coverage of workers through a shift from informal arrangements to existing formal labor relations will prove difficult; and (ii) alternative methods to increase access to health and pension coverage are well-worth exploring. The rest of these main findings concentrate on the conclusions of the study regarding the determinants of informality and what prompts businesses to move towards formality.
7. What is an informal business? Micro and small entrepreneurs consider themselves to be formal if they pay (some) taxes, have a tax ID number and a municipal business license. Micro and small business owners do not typically consider that not having workers on the payroll is being informal. At some level business owners know that having workers on the payroll is mandated by law but the practice of not doing so is so widespread that it does not register with them as an informal practice. This implicit definition shared by micro and small entrepreneurs of what makes a business formal or informal is an important starting point. It helps to identify that any policy aimed at formalization of labor relations (or any aspect absent from the implicit definition) will face key communication and enforcement challenges.
8. As businesses grow they tend to become more formal – but not in the area of labor relations. The first step of formalization among micro and small businesses is to obtain a tax ID number (Registro Único de Contribuyente, RUC) and a municipal license. Most of these businesses pay taxes on some of their actual income. As micro and small businesses grow businesses consider incorporating the business into a separate legal entity with limited liability. However, at the same time informal labor relations persist even as the business grows. Businesses with 11 to 50 workers display a very complex mix of labor relations among their workers. But these complex relations are largely informal even among the core group of stable workers.
9. The trajectory of businesses towards formality is driven by how the costs and benefits across different dimensions of informality change as the business grows. The study draws on both a quantitative survey of 802 micro and small businesses as well as on qualitative data gathered from seven focus groups, interviews, and case-studies. Overall, the different sources of evidence presented in this study present a consistent pattern of how micro and small entrepreneurs make their choices regarding whether to cross into formality or to remain informal. This pattern, which we now discuss in more detail, can be characterized in broad terms as reflecting largely the costs and benefits faced by business owners. At the same time, some evidence was also found that certain behaviors may be partly explained by a persistent ‘culture of informality’ by which micro and small businesses would remain informal simply because this is the societal norm.
10. In many cases, the main driver behind the formalization process is the fact that enforcement makes it costly to remain informal. In the areas of business licensing and paying taxes the costs of remaining informal increase notably as the business grows. Enforcement is the critical factor affecting the decision to obtain a municipal license which otherwise is seen as conferring no benefits to the business. In addition, businesses perceive the process to get a municipal license as unnecessarily burdensome and arbitrary. Thus, micro and small businesses exploit any opportunity to avoid compliance. Businesses are less likely to get the municipal license if they operate in sectors such as textiles because they can operate workshops without being detected. In some cases, businesses prefer to pay off inspectors rather than obtain the license, but as the business grows so also does the number of visits by inspectors, thus making the strategy of paying them off not worthwhile, most businesses end up obtaining a municipal license.
11. Businesses perceive benefits from formalizing only in the area of paying taxes and business incorporation. While enforcement of taxes is a key factor in ensuring compliance, businesses do see benefits in being registered with the tax authorities and regularly paying taxes (at least on some of their actual income). Benefits from formalizing in the area of paying taxes include an expanded client base since the business can issue receipts and can therefore sell to larger clients that require receipts and also to the state. In addition, there is some limited evidence to show that being registered with the tax authority and in a position to show regular payment of taxes may improve access to credit. The analysis also suggested that incorporating the business may be an important step in the formalization process. Micro and small business owners consider that incorporating the business under a separate legal entity with limited liability provides not only a way to preserve the individual patrimony but also business opportunities as the business gains credibility in the marketplace.
12. But the existing tax regimes may need to be fine-tuned as they currently do not encourage formalization. This applies when special tax regimes do not encourage micro and small businesses to move to the general regime as they grow and to incorporate as separate legal entities. Few businesses choose to file taxes under the special regime for corporate income tax (Régimen Especial de la Renta, RER). Instead businesses prefer to remain under the much simpler, but more onerous, simplified regime (Régimen Único Simplificado, RUS) or the general regime – despite the fact that the latter imposes the full set of requirements designed for larger enterprises. These filing patterns suggest that compliance costs may be high under the RER – discouraging businesses from moving from the RUS to the RER. In addition, the constraint under the simplified tax regime (RUS) by which most legal entities are prevented from filing taxes under that regime, may result in businesses choosing to remain operating as natural persons for longer than they otherwise would, which may have a negative impact in business access to credit and market opportunities. Overall, current practices contrast with the goal of having small businesses under the special regimes and larger businesses under the general regime.
13. In the absence of enforcement, businesses keep informal labor relations and explain them partly on the grounds of a need for greater flexibility. The very fact that businesses do not consider this an aspect of informality is indicative of how prevalent it is. Based on the survey conducted for this study more than 80 percent of micro and small businesses have no workers with a contract. This high number is unsurprising given what we know from the household survey about the economically active population in Peru (again around 80 percent of the labor force without a pension). What is more remarkable is that the proportion of businesses with no workers on the payroll decreases only slightly among businesses with 11 to 50 workers, of which approximately two-thirds have no workers on their payrolls. As for the reasons why labor relations are so informal, the analysis from the focus groups suggested that in part this stems from a need to keep flexible labor relations in what is a rapidly changing and highly cyclical marketplace. While this may be true for smaller businesses, this reason is also claimed among larger businesses of 11 to 50 workers, which typically have a stable group of core workers yet often those core workers are still reported to be service providers who simply issue receipts for their services (recibos por honorarios).
14. Micro entrepreneurs claim that the minimum wage and holiday pay impose not only a high burden but are also hard to reconcile with their preference for piece-rate pay arrangements. In some cases the foremost concern of micro and small business owners with the formal requirements regarding minimum wage and holiday pay does not appears to be their level but the fact that they perceive it to be in opposition to the piece-rate pay arrangement (destajo). Micro entrepreneurs are often confused when it is suggested that a minimum wage could be paid as a floor for their workers’ salaries. This perception is all the more puzzling given the complex mix of labor arrangements that micro and small businesses actually have. One interpretation of this finding is that minimum wages would be in fact binding for a large proportion of the workforce (for more than half of the workforce if the survey results are taken at face value). Hence the minimum wage may truly have the disincentive effects on effort that micro entrepreneurs fear. The survey conducted for this study provides some supportive evidence that two-thirds of all businesses surveyed consider that their business is not productive enough to allow paying the minimum wage. At the same time, the survey also provides evidence that there is a group of workers who earn more than the minimum wage but who are not on the payroll, for which the preference for piece-rate pay arrangements (on the side of the employer) and for higher take-home pay instead of benefits (on the part of the worker) seems to play a role.
15. Firing costs are also perceived to be high and a deterrent to include workers on the payrolls. Most micro and small entrepreneurs consider that the compensation that workers receive upon been fired is not only too high but also a more important factor than the actual wage to be paid in explaining why workers are not on the payroll. Firing is also perceived to be complicated and the process prone to legal disputes and costs. In this regard, and somewhat paradoxically, there may be an incentive to incorporate the business into a legal separate entity as a way to protect the entrepreneur from labor-related litigation. In addition to the level of firing costs, the study uncovered evidence that the de facto severance payments differ considerably from the de jure severance payments. To the extent that this results in increased uncertainty about the true costs of firing, this may further discourage the formalization of labor relations.
16. Overall, micro and small business owners have limited information about the regulatory frameworks affecting them. Most notably, the Special Labor Regime, which provides for a much reduced burden of social benefits on the part of the employer, is virtually unknown among micro and small entrepreneurs. The limited knowledge of the Special Labor Regime for micro businesses highlights the communication challenges implied in addressing the issue of labor informality. In addition, there is limited information among micro and small entrepreneurs about the new regulatory framework for municipal business licensing. The interaction between the entrepreneur and the state is also made more difficult by the existence of different definitions of what constitutes a micro or a small business for tax and labor purposes and, more importantly, the fact that those definitions overlap only partially with each other.
17. Micro and small businesses typically obtain information about the costs and benefits from their peers or from an accountant to formalize their business. This finding, which emanated from the qualitative research conducted for this study, helps to explain why, for example, factors such as owner education do not affect the choice of tax regime. The choice of tax regime is effectively not made by the owner but by the accountant. This qualitative research suggests that a similar pattern may also affect other decisions to formalize, particularly the decision to incorporate the business as a separate legal entity.
Policy implications
The following conclusions are meant to serve as input for the ongoing policy dialogue with the authorities of the Government of Peru (GOP). Policy implications that can be implemented in a relatively shorter time-frame will be discussed here first, followed by those that will pose greater challenges to implement.
‘Quick-wins’
18. Unify the definition of a micro and small enterprise for tax and labor purposes. While there is no standard international practice for what the criteria should be to consider a business to be a micro and small enterprise (MSE), the guiding principle should be one of clarity. The preferred solution is to have a single definition agreed by all different ministries and applied consistently. Alternatively, the number of criteria that a business has to meet to qualify under the different regulations could be reduced. One possibility would be to define eligibility for certain tax regimes on the basis of turnover and to define eligibility for the special labor regime on the basis of the number of employees. The decision to include additional criteria as a way of preventing certain businesses from ‘getting through’ under a more simple framework (e.g., a capital-intensive and high-turnover business with few employees would qualify for the special labor regime) ought to be carefully weighed against the disincentive that complexity and partially overlapping criteria pose to formalization.
19. Eliminate the register of eligible suppliers to the state in order to expand the benefits of formalization. Peru mandates that 40 percent of all state purchases to be sourced from MSEs. In practice less than 20 percent of purchases are sourced from MSEs. In part, the effectiveness of this legal requirement is weakened by the additional bureaucratic and cost burden that MSEs have to face in order to compete for state contracts, as all businesses wanting to supply the state have to pay to be registered on a list of eligible providers. A way to reduce the bureaucratic burden on micro and small business would be to eliminate the register of eligible suppliers, establishing that all formal businesses (e.g., those with a RUC number) are eligible to bid in public procurement tenders by default. If necessary the GOP could replace the register of eligible suppliers with a listing of ineligible suppliers: those fined by SUNAT or the Ministry of Labor. This change would have some impact on expanding the benefits of formalization without unduly compromising the integrity of the system since the register of eligible suppliers does not carry inspections. Overall, improved market access must be emphasized as a key benefit of formalization, given that micro and small business owners already perceive this a benefit of formalizing in terms of paying taxes and of business incorporation.
20. Continue with simplification efforts in municipal business licensing. In Lima the Tramifácil project, with support from the IFC, reduced the time to obtain a license from a month to a week and cut the number of procedures from 33 to five. Such efforts are being expanded across an increasing number of municipalities and are expected to alleviate somewhat the concerns of micro and small business owners regarding the bureaucratic burden posed by municipal business licensing. To ensure that the costs of the municipal license remain affordable, municipalities need to ensure that, as provided by the regulatory framework, the fees charged to businesses reflect only cost recovery considerations. The cost of the municipal license in 2007 ranged from 1.7 percent of per capita GDP in Lima to 9.7 percent of per capita GDP in Huancayo. These figures are relatively high compared to a selection of 65 municipalities in the Latin America and the Caribbean region monitored by the IFC Municipal Scorecard, in fact Huancayo was the lowest ranked municipality of all 65, and Lima, while being the highest ranked in Peru, was only the nineteenth of the regional sample.
21. Review the costs of complying with the different tax regimes to identify ways to reduce them, and re-calibrate the simplified and special tax regimes. Costs of complying with the requirements in the different tax regimes may be a significant factor affecting the choice of tax regime under which businesses are filing their taxes. However, more analysis is needed as the drivers of the choice of tax regime remain unclear. The restriction that only natural persons can file under the simplified regime: RUS, may discourage businesses from incorporating into separate legal entities, this study suggests that this is an important step in the formalization process.
22. Step up communication efforts, possibly in partnership with associations of accountants, those who are close to the micro and small entrepreneurs. The finding that micro and small entrepreneurs often based their decisions to formalize on the information they gather from other MSEs poses a challenge for effectively communicating with them. However, the finding that MSEs also rely heavily on the accountant that files their taxes opens up an opportunity for the GOP to partner with associations of accountants to improve the effectiveness of efforts to relay relevant information, such as that regarding the labor regime available to micro enterprises.
23. Target businesses that already participate in some state programs (purchases, etc) to provide information relevant to those businesses. An additional opportunity to improve the reach of information to MSEs is to make the most of the fact that some MSEs are already in contact with the state through participation in a number of state-sponsored programs. Yet the survey evidence suggests that even among these MSEs knowledge of the Special Labor Regime was poor. The GOP may therefore want to explore making use of the opportunity to be in contact with the MSEs to introduce this information and to present options like the Special Labor Regime as an opportunity to reduce costs compared to the general labor regime. An additional point of contact with the MSEs would be through the SUNAT, though this is likely to be a less efficient way to relay information since the set of businesses dealing the state-sponsored programs is in effect a self-selected group. For municipalities to efficiently perform as a link in the relays of information, an even bigger effort would be required given the still broadly negative view that micro and small entrepreneurs have of the municipalities.
Longer-term challenges
24. Consider ways to expand access to health care insurance and pensions that do not necessarily involve including workers in the general labor regime. Given the intrinsic difficulties in establishing the link between informality and business performance measures, the econometric results presented in this study must be interpreted with great caution. However, they suggest that the key negative aspects of informality relate to the lack of social protection of workers. Given the tough hurdles that need to be overcome to make the labor regulatory environment more conducive to the expansion of formal employment in MSEs (see challenges below), it seems worthwhile to explore the feasibility of broad access schemes that will help expand health care insurance and pension coverage. In exploring policy options the potential impact of reforms on the incentives to contribute under the existing system needs to be carefully examined. A particular concern to bear in mind is that super-imposing non-contributory programs on top of a contributory system may actually create incentives for informality.
25. Alleviate the burden of labor regulations on micro and small businesses, especially regarding social benefits and firing costs. The burden of labor regulation in Peru is among the highest in Latin America, as the first phase of this study documented. For example, in the Doing Business indicators 2008, Peru had a difficulty of hiring index of 44 (compared to 37 for the region on average). The new evidence uncovered in preparation of this second phase provides further support to the conclusion that labor regulations remain a barrier to formalization. The evidence compiled for this study suggests that benefits such as holiday pay and high firing costs are perceived to be among the most important factors which deter businesses from including workers in their payrolls. In addition, severance payments that workers receive de facto are substantially (and somewhat unpredictably) lower than what workers are entitled to de jure. This adds to the uncertainty about what the actual firing costs may turn out to be, and hence firing costs and procedures may act as a deterrent to formal employment. Reducing firing costs to bring them in line with the average de facto severance payments would reduce uncertainty. An important caveat, however, applies to the case of micro businesses since most of these entrepreneurs do not know about the reduced benefits and firing costs that the Special Labor Regime for micro businesses allows. Expanding the coverage of this special regime to larger businesses may provide an alternative, though crucially reform efforts would be in vain if information failed to reach the MSEs.
26. Consider ways to improve the minimum wage regime so that they become less of a binding constraint, including considering the appropriateness of region-specific minimum wage rates. The survey of micro and small businesses conducted for this study provides evidence that the minimum wage is perceived to be as too high, especially for the smaller businesses. In fact, the statutory minimum wage is slightly below the median wage for the economy as a whole. The level of the minimum wage ranks high for businesses among the reasons why workers are not paid the minimum wage. More than 70 percent of businesses with 1 to 5 workers consider that their business is not productive enough to pay the minimum wage to workers. This proportion is lower for larger businesses but even of those with 11 to 50 workers, more than half of surveyed businesses consider that they are not profitable enough to pay the minimum wage to workers.
27. Once an adequate regulatory labor regime is in place it is important to enforce it firmly and consistently. The combination of weak enforcement and overly strong de jure labor regulations may undermine the rule of law and cultivate a social norm of non-compliance. This calls for improvements in the regulatory regime, as noted above. It also calls for a more effective enforcement once an adequate regime is in place. The role of weak enforcement was also highlighted by the results of the survey. The finding that the share of workers outside the payroll is higher than the share of workers earning the minimum wage indicates that there are workers for which the minimum wage is not the binding constraint impeding formalization. In turn, this finding suggests that opportunistic behavior may be a driving force of labor informality, at least for some workers. Moreover, the analysis found some support for the role of labor inspection rates in affecting the probability of a business to employ workers under formal labor relations. Improving the enforcement of labor laws will likely require an increase in resources given the number of inspectors that the Ministry of Labor (MTPE) currently has at its disposal. In this regard, the addition of 104 new labor inspectors to the MTPE, bringing the total to 450, brought the number of inspectors to around 1 per 40,000 members of the economically active population. This is still a low figure as Peru would need approximately three times as many inspectors to reach the benchmark suggested by ILO (2006) for industrializing countries of 1 inspector per 15,000 workers. Peru would still need to almost double its number of inspector to reach the ratios observed in Argentina, Brazil, or Chile, all of which have ratios of 1 inspector per 20,000 to 25,000 workers.
Introduction
1. This report, the second part of a programmatic study, focuses on the trajectories of Peruvian businesses towards formality. This is the second phase of a programmatic study on informality in Peru the objective of which is to analyze the causes and effects of informality so as to provide policy options for a reform agenda. The first phase took stock of the characteristics of informality, and focused on how the labor market and labor legislation in Peru may be associated with informality (World Bank, 2007a). While the first phase of the study noted strong incentives to remain informal, particularly due to labor and tax codes, it also argued the need to better understand the businesses’ perspective on the costs and benefits of informality and to map the steps that businesses need to take towards formalization.
2. ‘Formality’ is better understood as having different dimensions. It is well known that informality is not a straightforward concept (Box 1). As a result, it is not easy to agree on a single definition of informality or to measure it easily. The important conclusion to draw from this is that informality can be better understood as being a multi-dimensional concept covering areas such as business licensing, tax, labor relations, and (as discussed below) also business incorporation. The focus of this study is to document the trajectories of businesses towards formality along these different dimensions. The interest in the trajectories towards formality is rooted in the fact that, regardless of their size, most businesses have some characteristics that are to a degree informal. Hence, answers to questions about which dimensions of formality are achieved first, and why, can help the policy discussion on how to reduce different aspects of informality.
|Box 1: What do we mean by informality? |
|The term informality means different things to different people. Some are concerned about workers not enjoying the protection of |
|existing labor laws, with the corresponding impact on equity and welfare. Others are concerned about efficiency and productivity, |
|as informality is seen as being associated with firms that are too small. Informality is also a source of concern for those who see|
|it as eroding the legitimacy of public institutions and as suggestive of poor policy regimes. Reflecting in part these different |
|concerns, multiple measures of informality have been advanced in the literature, commonly classified in two broad groups: |
|(i) The productive definition of informality, which focuses on the characteristics of the productive unit. One such productive |
|measure of informality is the one traditionally used by the International Labor Organization, which defined the informal sector as |
|economic units “with scarce or even no capital, using primitive technologies and unskilled labor, and then with low productivity” |
|(ILO 1991). To make this definition operational, it is common to assume that the self-employed, family units, and |
|micro-entrepreneurs and their employees fit under the description of activities with low capital and low productivity and are |
|therefore considered to represent informal employment. |
|(ii) The legalistic definition of informality, which focuses on coverage of workers by mandated social protections. A common |
|example of a measure of informality inspired by the legalistic definition of informality is to consider that a worker without |
|rights to a pension is an informal worker. This approach has the advantage of recognizing that informal employment can be found in |
|firms of all sizes and in all sectors of the economy. It is particularly useful in the case of Peru since participation in the |
|state pension system is mandatory for all workers on the payroll of a firm (strictly speaking, this participation is optional for |
|workers under the special labor regime for micro firms with less than 10 employees, but participation in this regime is limited to |
|only around thirty thousand micro firms, see Box 4). |
|Informality covers many aspects, and in practice many indicators of informality are widely applied. While helpful, the use of other|
|proxies creates the potential for ambiguity in the meaning of: ‘informality’. To that end, we will now make clear which proxy |
|measure we are using for informality. |
|This box draws from Chapter 1 of World Bank (2007b). |
3. In this report we explore four of those dimensions of formality: business licensing, tax, labor relations and pensions, and business incorporation. In this report we take a pragmatic approach by exploring four dimensions of ‘formality’: business licensing, tax, labor relations and pensions, and business incorporation. Some of these dimensions are more easily understood as referring to the formality-informality divide: to be formal a business has to comply with business licensing requirements and pay the required taxes. Regarding labor relations, an entrepreneur could in principle have no employees on the payroll and still be in full compliance with the law, as it is possible to pay for services through a contractual relation that is not of an employment nature. However, such a situation goes against the spirit of the labor protection legislation and, in the legalistic definition of informality, is typically considered to be one of the dimensions of informality. Finally, the report also considers one more dimension of formality: the incorporation of a business as a separate legal entity. A business person can legally operate as a natural person. But, as will be shown below, entrepreneurs themselves consider this an important aspect of the formalization process. It is also worth stressing that this report is not only concerned with illegal economic activity, which by definition, cannot be conducted in a formal way.
4. The report has been designed and prepared in close cooperation with the authorities to help draw implications for the Government’s priority of reducing the size of the informal sector. This suggests that there is much to gain from a detailed analysis of what is formal and informal at different stages of the development of a business. Documenting the reasons why and when a business chooses to formalize and the reasons why it may do so with regard to one facet of informality (say tax) but not another (say labor) is of interest to Government authorities as they consider policies that will help increase the speed with which businesses traverse the trajectories toward formality. It is also an area where, as identified in the first phase of the study and the in concept stage of this report, the World Bank can add value to the existing literature on informality in Peru.
|Figure 1.1: Informality in Peru and other countries in Latin America and the Caribbean |
|Percent of workers that are informal, according to different definitions |
|Informal workers (productive definition) |
|[pic] |
|Workers without a pension |
|[pic] |
|Workers without health insurance |
|[pic] |
|Workers without a contract |
|[pic] |
|Note: Data for different countries do not all refer to the same year. * Refers only to salaried workers. |
|Source: Gasparini and Tornarolli (2006) and ENAHO (2006) for Peru. |
5. The interest of the authorities in understanding the trajectories towards formality stems from their development objective of reducing informality. The Peruvian authorities’ interest is high compared to other countries in Latin America and the Caribbean according to some measures (Figure 1.1). The Government has a formally stated goal of reducing informality by one-third by 2011. Most recently in April 2008 President García referred to informality as the “slavery of the twenty-first century” and stressed that, without access to a pension, the living standards in old age of many Peruvians are at risk.[1]
6. The first phase of the study raised a number of questions about informality in Peru that required additional data and further analysis. In broad terms, the first phase of the study argued that informality is driven by: (i) strong incentives to remain informal, particularly related to the high cost of labor and tax codes; (ii) bureaucratic obstacles to formalization; (iii) insufficient incentives to become formal, including greater access to credit, markets, and government-funded business services, combined with enforcement and penalties for those who do not formalize; (iv) a pervasive “culture of informality” that encourages regulation evasion; and (v) a frequently-changing array of laws and regulations which inhibits long-range planning and acts as a disincentive to formality. However, the first phase of the study also noted that it was often not possible to identify which factors were most critical given the limited availability of data.
7. The path towards formality reflects the choices made by businesses to stay informal or to formalize. This report explores why and how firms make those choices. Regardless of the measure with which one proxies informality, a common thread is the fact that informality reflects a lack of compliance with legal norms. This raises the question as to why agents are not in compliance with the law. The answer to this question has often been framed in terms of the exclusion of workers, which are involuntarily left outside formal institutions and are also without the protections given to formal workers. However, a second view emphasizes that there is an exit dimension to the actions of agents, by which firms and workers may simply opt into informality not finding any net benefit of interacting with the state (World Bank 2007b). A key objective of this report is to contribute to a better understanding of this exit dimension of informality in Peru from the perspective of the small business owner or self-employed person. To do so the World Bank has gathered new firm-level data to complement existing information.[2]
8. To this end, this report provides new business-level evidence on the determinants of informality in Peru. The main value added of this study is to draw from new business-level data to shed light on the determinants of informality in Peru and in the policy debate. Therefore, the focus throughout the text will be to present and analyze this new information. Design and analysis of the research has been greatly influenced by recent efforts to explain the phenomenon of informality in Latin America, most notably the World Bank’s Informality. Exit and Exclusion flagship report of the Latin American and Caribbean Vice-Presidency (World Bank, 2007b). For the sake of brevity, references to broader regional trends and to theoretical considerations are kept to a minimum throughout the text. The interested reader is referred to the flagship report for a broader context and for a discussion of theoretical issues. For an international perspective on informality in Peru the reader is referred to the report produced during the first phase of this programmatic study.
9. By focusing on business-level data the report helps to fill a gap in the literature. As noted in the first phase of this programmatic study there are only a limited number of studies that address the determinants of informality in Peru using business-level information. Jaramillo (2004) asked a sample of firms in the garment industry in Lima for the reasons that explained their decision to become formal: 85 percent answered access to more suppliers and customers; 70 percent answered access to credit from a formal source; 63 percent to avoid the payment of fines and 40 percent to avoid the payment of bribes. Yamada and Chacaltana (2007) document six successful cases of firms expanding and generating employment. Access to exports markets was an important factor for firm expansion in the cases studied. The Municipal Scorecard report for 2007 asked firms that had obtained their business operating licenses and construction permits the main reasons why they decided to go formal. These firms identified not paying fines and law enforcement as the main reasons, while access to the judicial system and better credit were ranked as the least important reasons. While informative, these studies do not always provide systematic treatment of the different dimensions of informality nor do they have a broad coverage in terms of the number of businesses polled.
10. The report also studies the impact of informality on businesses’ profitability and access to credit. The first contribution of the report is to study the factors affecting informality controlling for a large number of business characteristics. A second contribution of the report is to analyze the impact of those factors. This requires econometric analyses that can establish the ‘causal’ links between the determinants of informality and variables of interest such as profitability or access to finance. While these analytical techniques have shortcomings, the estimates provide a contribution to the discussion of informality in Peru as a careful econometric analysis of the impacts of informality that was not available previously.
11. A key building block for the analysis in this report is a dedicated survey of 802 micro (up to 10 workers) and small (11 to 50 workers) businesses, both formal and informal. The National Household Survey (Encuesta Nacional de Hogares, ENAHO) provides a good basis for determining the extent of informality in Peru. It allows us to provide a clear answer to the extent of informality according to the legalistic definition, since it contains information on whether the respondents to the survey are covered by a pension or not. There is also information that can be used to construct a measure of informality according to the productive definition (as was done in phase I of this programmatic study). However, the objective of this study is to move one step further and explore the impact and determinants of informality. To answer these questions we need a firm-level data set of both formal and informal businesses that will allow us to control for a large number of business characteristics such as size, age, education of the owner, etc., that may be thought to affect the choices of firms on their trajectory towards formality. To this end the World Bank commissioned a dedicated business survey, as detailed in Box 2.[3] While the survey conducted provides us with a cross-section of data by including questions such as ‘how long did the business operate before obtaining a license?’ it allowed us also to obtain information about the trajectories of businesses towards formality.
|Box 2: A dedicated survey to study informality in Peru |
|To better understand the factors behind informality in Peru the World Bank commissioned a dedicated survey of businesses, both |
|formal and informal. A total of 802 businesses were interviewed face-to-face in five cities: Arequipa, Cusco, Huancayo, |
|metropolitan Lima, and Trujillo. These five cities were selected to reflect a cross-section of urban centers, accounting for |
|more than 10 million inhabitants in total or around 36 percent of Peru’s estimated population. We restricted the survey to |
|cities since urban informality has been the focus of the debate in Peru, largely on account that it is perceived to be in cities|
|where the potential for reducing informality is greatest. In addition, informality in urban and rural areas may not share common|
|characteristics. |
|Conducting a survey of both formal and informal businesses poses the challenge that there is no readily available census data to|
|use as a frame from which to draw a random sample of businesses. To ensure as much as possible a random sample of respondents, |
|the sampling was designed as a three step process. First, on the basis of the population census, a certain geographical area |
|within a city was selected at random. Second, an enumerator was sent to that particular geographical area and was asked to list |
|all businesses that could be found. While this necessarily introduces some selection bias, it is a pragmatic approach for |
|addressing the complex issue of how to construct a frame from which a random sample can be drawn with limited resources. It is |
|also an approach that has been successfully used in other cases (De Mel et al., 2007). Third, a random sample of businesses to |
|interview was drawn from that list. |
|For businesses in metropolitan Lima (except those in transport) the first and second steps of the methodology were unnecessary |
|since the survey firm already had a proprietary census carried out in 2007 of more than 100,000 firms covering the sectors of |
|activity of interest. A pure random sample of informal and formal businesses would have resulted in a very large number of |
|single-person businesses and very few businesses of 6 to 10 employees and of 11 to 50 employees. Therefore stratification quotas|
|by city, industry, and firm size were applied to ensure that the sample covered sufficient observations to enable a statistical |
|analysis of the results by different firm sizes and other categories (see Chapter 2 for descriptive statistics). |
|Only businesses operating in seven sectors of the economy were surveyed. The selected sectors were chosen to represent a broad |
|cross-section of manufacturing and services activities: (i) shoe and leather manufacturing; (ii) textile and apparel |
|manufacturing; (iii) wood products and furniture manufacturing; (iv) metal products manufacturing; (v) retail sales of |
|foodstuffs; (vi) transport by land; and (vii) restaurants and hotels. In 2006 the combined seven groups of activity accounted |
|for around 30 percent of Peru’s economically active population, and a somewhat higher figure of employment in micro and small |
|firms. Transport by land accounted for 4.6 percent of GDP in 2006, restaurants and hotels for 3.7 percent, textile and leather |
|manufactures for 2.2 percent, metal products manufacturing for 1.2 percent, and wood products and furniture manufacturing for |
|0.5 percent of GDP. However, it is not possible to exactly match the weight of the retail sales of foodstuffs in GDP (retail |
|activities as a whole account for around 14 percent of GDP). |
| |
12. Focus groups, in-depth interviews, and case studies complemented the quantitative data gathered from the quantitative survey. The dedicated survey of businesses was complemented with qualitative information gathered from seven focus groups and 15 in-depth interviews with micro and small entrepreneurs. Participants in focus groups were micro and small entrepreneurs with at least two years in business. This allowed us to probe focus group participants about their trajectory towards formality. Participants in focus groups were grouped according to the size of their businesses. In particular, two focus groups were dedicated to entrepreneurs with up to 4 workers, two more for entrepreneurs with 5 to 10 workers, and three groups with owners of businesses with 11 to 50 workers. Participants in the focus groups undertook their business in one of the following areas of activity: manufacturing (textiles and apparel, wood and furniture, leather and shoes, metal products), retailing of foodstuffs, transport, hotels and restaurant, and construction. The in-depth interviews were targeted at business owners who also took an active role in an association of micro and small businesses (gremios), which tend to be better informed. This ensured that the data gathering effort polled those better informed micro and small business owners while avoiding that their presence in a focus group would affect the group dynamic and that they would come to dominate the focus group discussion. In-depth interviews were held with leaders representing associations of micro and small businesses in a range of activities: manufacturing of wood products and furniture (four interviews); manufacturing of metal products (three); textile and apparel manufacturing (three); shoe and leather manufacturing (one); retail of foodstuffs (one); transport (one); and construction (one). Different research guides were prepared for the focus groups and for the in-depth interviews. Both the focus groups and in-depth interviews took place in January 2008 in metropolitan Lima.
Informality in the sectors selected for the survey
13. The degree of informality observed in the sectors selected for the survey is close to the one seen for the economy as a whole (see Table 1.1). In addition to allowing us to compare measures of the legalistic and productive definition of informality, the ENAHO captures other characteristics of a business, where a respondent works, that can be thought of as reflecting how formal or informal the business is. In particular, the ENAHO contains questions on whether the worker has healthcare coverage; has a contract or not; whether the employer is a business that is registered with its own legal personality; and whether the business where the respondent works keeps any accounting books. As noted in the first phase of the study, informality in Peru is high regardless of the definition or aspect of it that one chooses to examine. As shown in Table 1.1, the same is also the case for the sectors selected to be included in our dedicated survey. However, the ENAHO is not a good source of information for understanding the trajectories of businesses towards formality since it does not provide us with information as to the reasons why businesses choose to remain informal or to formalize.
Table 1.1: Measures of informality based on the household survey in the sectors selected for the survey and in the economy
| |Percent of economically active population … |
| |
|Sectors selected for the survey | |All economic activities |
|[pic] | |[pic] |
|Source: World Bank staff calculations based on ENAHO. |
14. The five cities included in the survey are located in regions with a diverse incidence of informality – within the high rates seen across the country. By including businesses from Trujillo (La Libertad), Huancayo (Junín), and Cusco, the survey draws from cities in regions where the share of workers without a pension is relatively high (above 85 percent) compared to Lima and Arequipa (70 percent), as shown in Figure 1.3.
|Figure 1.3: Map of informality prevalence by region |
|Percent of workers without a pension (2006) |
| |
|Note: Informality rates are shown at the departmental level since this is the most disaggregated geographical unit for which the|
|annual ENAHO survey provides a representative sample of the population. |
|Source: World Bank staff calculations based on ENAHO. |
15. Even though urban areas are typically richer, the choice of cities for the survey reflects a range of average incomes and incidence of informality. Informality is highly correlated with income levels, as Figure 1.4 shows. This is an important factor when designing any research into informality and when interpreting the results. In our case, the inclusion of cities such as Cusco and Trujillo ensured that the dedicated survey did not only cover the richest areas of the country. Finally, the positive correlation between average incomes and formality makes the importance of exploring possible directions of causality very clear: is it that formality contributes to higher incomes or that those with higher incomes self-select themselves into more formal arrangements? These questions are explored in Chapter 3, which includes an analysis of the impact of informality on the profitability of businesses.
|Figure 1.4: Informality prevalence by region and income per capita |
|Informality as measured by the ratio of workers without a pension (2006) |
|[pic] |
|Source: World Bank staff calculations based on ENAHO and INEI. |
16. The sectors selected for the survey are also representative of the economy as a whole with regard to trends in informality. Informality, as measured by the share of workers with a pension, has declined in the sectors selected for the survey in line with the decline observed for the economy as a whole. As measured by the proportion of workers without a pension, informality declined from around 87 percent in 2003 to around 80 percent in 2006. Informality also declined in the sectors selected for the survey, as shown in the left panel of Figure 1.5. These declines in the level of informality have taken place in a context of accelerating economic growth since 2004, as shown in the right panel of Figure 1.5. This evidence suggests that while informality may be a persistent phenomenon, strong economic growth has contributed to its reduction in recent years. However, using alternative indicators of informality based on the ENAHO, there has been no significant decline in recent years in the share of workers without a contract or working in businesses without a separate legal personality or without accounting books (Figure A.8 to Figure A.10 in Annex A).[5] In addition, one has to bear in mind that the decline in informality, as measured by the lack of access to a pension, has required ever increasing rates of economic growth, as shown in the right panel of Figure 1.5.
|Figure 1.5: Informality rate and economic growth, 2003 to 2006 |
|Informality as measured by the percent of workers without a pension |
|Informality rate for sectors selected for the survey and for | |Informality rate (all economic activities) |
|all economic activities | |and economic growth |
|[pic] | |[pic] |
|Source: World Bank staff calculations based on ENAHO and INEI. |
17. The remainder of the report reviews, in turn, the determinants of informality (Chapter 2) and its impact (Chapter 3). As part of the analysis of the determinants of informality the study identifies the trajectories of micro and small businesses towards formality. In addition, a number of boxes in the report pay particular attention to: (i) taxation of micro and small enterprises; (ii) sector-specific labor regimes; and (iii) unfair dismissal costs. These topics were selected in close cooperation with the authorities of the Government of Peru to address specific queries that the authorities had. In this regard the report contributes to the knowledge base for policy-makers by: (i) quantifying the tax burden on new capital investment by micro and small businesses under different tax regimes: (ii) providing a detailed compilation of labor regulations affecting different sectors; and (iii) producing a new data set that allows for a comparison between the payments to which a dismissed worker is entitled de jure and the actual payments that the dismissed worker receives after a conciliation process.
Determinants of informality
Scope: To explore why businesses choose to keep certain aspects of their operations informal we ask businesses themselves, through the dedicated survey and focus groups. We ask about businesses’ perceptions but also about their actual level of formalization along a range of dimensions and about a large number of characteristics of their businesses. This allows us to explore the determinants of informality econometrically.
Structure: The chapter is structured in four sections.
First, we provide information about the characteristics of the sample of businesses from which we are drawing information.
Second, we report what our respondents tell us, through the survey and focus groups, about the factors that drive their choices regarding formality and informality along a range of issues. This section is structured along four broad dimensions of informality: (i) business licensing; (ii) paying taxes; (iii) labor relations and access to a pension; and (iv) business incorporation.
Third, the chapter exploits the information from the survey to establish econometrically what factors affect the probability that a business is formal (as captured through some characteristics associated with formality). In addition, the chapter includes a number of boxes reviewing specific issues selected with the authorities as areas of particular interest: (a) taxation of micro and small enterprises; (b) sector-specific labor regimes; and (c) unfair dismissal costs.
Fourth, the chapter sums up the information from the different data sources, quantitative and qualitative, to describe the common paths towards formality among micro and small businesses.
A. Who is our source of information?
1. Businesses surveyed cover a broad spectrum of micro and small enterprises... Details of the actual businesses surveyed in terms of their size, location, and sector of activity is provided in Table 2.1. The qualitative data-gathering effort also took account of the heterogeneity of micro and small businesses. Therefore different focus groups were arranged for businesses of different sizes. In total, four focus groups were conducted with businesses of 10 or less workers and three focus groups were conducted with businesses of 11 to 50 workers. An additional source of information gathered was through in-depth interviews with micro and small business owners who are also representatives in associations (gremios) of micro and small businesses.
Table 2.1: Number of businesses surveyed
|By size |
|[pic] |
|Note: The underlying data is reported in the appendix in Table A.8. |
|Source: World Bank survey of micro and small businesses. |
B. What do micro and small business owners tell us?
2. The pattern of selective formalization as businesses grow reflects the perception of costs and benefits associated with each dimension of formality. The focus group technique and the in-depth interviews with micro and business persons provide us with some insight into the decision-making process regarding formalization. Table 2.3 summarizes the key considerations when making those decisions as reported by micro and small entrepreneurs in the focus groups and interviews.
Table 2.3: Benefits and costs of formalizing perceived by micro and small business owners
|Issue | |Benefits |Costs |Key rationale for decisions |Dominant force |
| | | | |regarding formalization |driving |
| | | | | |formali-zation |
|Munici-pal |Informal (not|Avoid paying the license |Possibility of fines and |Municipal license is perceived |Enforcement |
|business |having a |fee |payments to inspectors |to convey no benefits and as a | |
|license |license) |Avoid heavy bureaucracy | |heavy bureaucratic burden, | |
| | | | |often unreasonably enforced. | |
| | | | |As firms grow and are more | |
| | | | |easily detected, they obtain | |
| | | | |the license to avoid repeated | |
| | | | |fines. Firms operating behind | |
| | | | |closed doors further delay | |
| | | | |obtaining the license. | |
| |Formal |Avoiding fines |Annual fees | | |
| |(having a | |High cost of dealing with the| | |
| |license) | |bureaucracy | | |
| | | |Fines still possible due to | | |
| | | |unreasonable inspections | | |
|Taxes |Informal (not|Avoid paying taxes |Possibility of fines if |Registering with the tax |Enforcement and |
| |paying, no |Selling without receipts |detected |authority (getting RUC number) |expanding customer|
| |RUC, no use |makes tax evasion easier |Lost customer base due to |is perceived to be easy and not|base. |
| |of receipts) | |inability to issue receipts |expensive. Very limited |Key role played by|
| | | | |information about the tax |accountant |
| | | | |regime – decisions which are |(choosing tax |
| | | | |left to the accountant. |regime for smaller|
| | | | |As firms grow the risk of being|firms). |
| | | | |detected increases and the need| |
| | | | |to issue receipts makes firms | |
| | | | |register with the tax authority| |
| | | | |and pay taxes. | |
| |Formal |Avoiding fines |Paying the accountant | | |
| |(paying, |Slightly better access to|Tax payments, perceived to be| | |
| |having RUC, |credit for larger amounts|too high (same tax rate for | | |
| |using | |all businesses draws | | |
| |receipts) | |criticism) | | |
|Labor |Informal (no |Avoid paying social |None mentioned (some |Preference for pay by piece |Lack of |
|relations |staff in |benefits |recognize the need for health|rate (on grounds of |enforcement and |
| |pay-roll) |Greater flexibility in |care coverage but provide for|productivity) and desire for |need for |
| | |labor relations |core group of workers |flexibility dominate among |flexibility. Being|
| | |More incentives for |privately) |smaller firms. Firms claim that|able to sell to |
| | |productivity | |workers prefer higher take-home|larger |
| | | | |pay instead of benefits. |firms/abroad |
| | | | |Enforcement is not a key factor|(though this is |
| | | | |– as labor inspections are |generally a weak |
| | | | |rare. |factor) |
| |Formal (staff|None mentioned |Social benefits and minimum | | |
| |in payroll) | |wage are too costly and | | |
| | | |discourage hard work | | |
| | | |Makes firing costly | | |
|Business |Informal |None mentioned (perhaps |Limits customer base (cannot |Large differences across firm |Expanding customer|
|incorpo-rati|(work as |unaware of the |sell to the state) |size: smaller firms see no |base (selling to |
|on |natural |requirements for filing |Lack of a business brand |benefits and fear high costs. |the state and |
| |person) |under RUS) |limits customer base (large |Larger firms already |larger firms) and |
| | | |firms do not consider you |established as separate legal |improved access to|
| | | |credible) |entities see broad range of |credit. |
| | | | |benefits and point to limited |Key role played by|
| | | | |costs. |accountant |
| | | | |The requirement to be a natural|(providing |
| | | | |person to file taxes under the |information about |
| | | | |RUS was not raised, possibly |what it entails). |
| | | | |reflecting the fact that | |
| | | | |choices about tax regimes are | |
| | | | |not made directly by the | |
| | | | |business owner. | |
| |Formal |Expand customer base |Businesses with 1 to 5 | | |
| |(separate |(state, larger firms, |workers fear high fixed and | | |
| |legal entity)|exporting) |recurrent costs if setting up| | |
| | |Some perceive slightly |as a separate legal entity | | |
| | |better access to credit | | | |
| | |Larger firms note the | | | |
| | |benefit of protecting own| | | |
| | |capital | | | |
Source: World Bank focus groups and in-depth interviews with micro and small businesses.
Business licensing
3. The procedures for obtaining the municipal license draw heavy criticism from micro and small businesses. Evidence from the focus group analysis suggests that the municipal license is perceived to be an unnecessarily burdensome bureaucratic hurdle that conveys no benefits to the micro and small entrepreneur. The safety inspection (certificado de inspección técnica de seguridad en defensa civil) is perceived more as an opportunity for municipalities to obtain revenue from businesses than as a legitimate means to ensure the safety of operations. Checking compliance with zoning requirements is also perceived to be unnecessarily burdensome, as it is claimed that it may also result in an additional inspection. The business polled did not perceive the benefits of such regulations.[7] As an interviewee put it: “my business is located in an industrial park and I still have to pay for them to come and check that this is an area where one can set up a manufacturing business.” There is also the perception that municipal licenses need to be renewed every year, especially among the micro business owners, that a business needs to get a different license for every type of activity that they conduct. Overall, the micro and small entrepreneurs that were polled consider that the municipal license conveys no benefits to the business owner. A small entrepreneur that participated in one of the focus groups for businesses with 5 to 10 workers put it most starkly when he commented on the municipal license: “it is an obligation; it does not give you any benefit.”
4. Businesses have not yet perceived the recent improvements in the municipal licensing framework. To some extent businesses’ perceptions of municipal licensing do not reflect the latest changes in the regulatory framework, by which municipal licenses are to be issued with indefinite validity and can encompass several areas of activity (Framework Law of Municipal Licenses, Law 28976 of January 20, 2007). Evidence from the municipal licensing simplification project Tramifácil, supported by IFC, suggests that improvements in the municipal licensing administration are taking place, as reported in the IFC Municipal Scorecard.[8] The cost of the municipal license in 2007 ranged from 1.7 percent of per capita GDP in Lima to 9.7 percent of per capita GDP in Huancayo. These figures are relatively high compared to a selection of 65 municipalities in the Latin America and the Caribbean region monitored by the IFC Municipal Scorecard. In fact Huancayo was the lowest ranked municipality of all 65, and Lima, while being the highest ranked in Peru, was only the nineteenth among the regional sample.
5. The probability of being detected is the key factor affecting the decision to obtain a municipal license. Business owners state that the key consideration when deciding to obtain a municipal license is how likely they are to be inspected. Those operating behind closed doors, such as textile workshops that operate in relative quietness, are less likely to obtain a license even as the business grows. In some cases, especially among micro firms, the entrepreneur prefer to pay off inspectors, allegedly for as little as 20 nuevos soles according to information from the focus groups, rather than go through the hassle of obtaining the license. Those that expressed a preference to pay off inspectors said they do so partly because businesses fear that the license will become invalid should they change their activity, for example if they change the type of goods that they sell. As businesses grow, however, the costs of paying off inspectors increase and the cost-benefit calculus prompts business owners to obtain the license.
6. The survey results lend support to two conclusions regarding licenses: (i) they are perceived to have only one benefit: avoiding fines, and (ii) they are perceived to pose a heavy bureaucratic burden. Results from our dedicated survey of micro and small businesses confirms that most businesses perceive little benefit from having a municipal license other than avoiding fines and being in compliance with the law (left-panel in Figure 2.2). In addition, the perception that the process to obtain a license is overly burdensome is also reflected in the survey results. Thus, among businesses that do not have a license, factors that can be thought of as reflecting a ‘culture of informality’, such as the fact that no business like mine has a license, are not stated as the main reason for not having a license. This result holds even among the smallest businesses surveyed (right-panel in Figure 2.2) and is unsurprising given the definition of informality that respondents from the in-depth interviews and focus groups have in mind: an “informal” business is one that does not have a RUC number or municipal license and that does not typically give receipts to its customers.
7. There may be other channels, not explored in this report, whereby having a municipal license may convey benefits to businesses, particularly regarding greater access to credit. Not having a municipal operating license increases the probability for a business to be closed down and is therefore a risk factor that, in principle, creditors may want to take into account when allocating credit. We would therefore expect that businesses with a municipal license have greater access to credit. However, as the left-panel in Figure 2.2 shows, improving access to credit is perceived to be the main benefit of having a license only by very few entrepreneurs, and the econometric analysis shown in the next chapter does not refute this view. One possible explanation for these results is that having a municipal license may not affect the probability of getting a relatively small amount of credit. For larger amounts of credit the risks of a business being closed down due to not having a license may become too high and the creditor may start asking for evidence of a license after a certain loan amount. Given the design of our research it is not possible to corroborate or refute this hypothesis, simply because most businesses surveyed may not be sufficiently big to have crossed the threshold where not having a license may be a constraining factor for access to credit. These issues are explored further below.
B. What is the impact of informality on access to credit?
|Figure 2.2: Benefits from having a municipal license and reasons not to have one |
|Percent of businesses |
|Main benefit of having a license | |Main reason not to have a license |
|(single answer) | |(single answer) |
|[pic] | |[pic] |
|Note: Other includes ‘to avoid bribes’, ‘to attract new clients’, and ‘none’. |
|Source: World Bank survey of micro and small businesses. |
8. Cost-benefit calculations drive businesses’ decision to obtain a license, enforcement plays a key role. Besides asking about the main reason for not having a municipal license, the survey also questioned business owners without a license in more detail about whether certain reasons had played a role or not in their decision not to have a license. The results suggest that factors related to the costs of getting a license were consistently perceived as more important than lack of information or other factors that one can think of as reflecting a ‘culture of informality’ (Table 2.4). A detailed econometric analysis is presented below in section ‘C. Econometric analysis of the determinants of informality.’ For now, it is simply worth noting that the econometric results are consistent with the view that businesses in sectors of activity that are more visible to the authorities are more likely to obtain a license. However, as the regression analysis will show, a variable specifically capturing the probability of inspection by city and by industry fails to significantly explain the probability of a business obtaining a municipal license. This latter result could reflect difficulties in distinguishing econometrically between the information captured in the different variables (the sector-specific variables and the variable with the inspection rate). Additionally, it could also reflect the possibility that, as businesses internalize the higher probability of being detected by being more likely to obtain the license, the municipalities do not need to inspect those businesses all that often. Therefore, ex post, there would be no significant difference in inspection rates by sector.
Table 2.4: Reasons for not having a municipal license
In brackets the percent of businesses without a municipal license that reported that this factor was one reason why they do not have a license
| |Cost-benefit factors |‘Culture of informality’ factors |
|More important |The process is too time – consuming | |
| |(69 percent) | |
| |The costs of operating a business with a license are too high| |
| |(63 percent) | |
| |The process is too expensive |My business is too small to have a license (57 |
| |(56 percent) |percent) |
| |I see no benefits in getting it | |
| |(55 percent) | |
|Less important |The forms are too complicated |There is no obligation to get it |
| |(46 percent) |(46 percent) |
| |No point obtaining it since fines are rare |No business like mine has a license (42 percent) |
| |(37 percent) | |
| |To get the license they ask for bribes |I do not know how to obtain it* |
| |(36 percent) |(40 percent) |
Notes: Based on responses by the 268 businesses without a license. See Table A.11 in the annex for a breakdown by business size. * This factor may also reflect genuine information constraints.
Source: World Bank survey of micro and small businesses.
Paying taxes
9. Obtaining a RUC number is relatively easy, but business owners know little about tax issues and often rely on third-parties for decisions regarding taxes. Evidence from the focus groups suggests that obtaining a RUC number is straightforward and imposes a limited burden. Having a RUC number and paying taxes (on some of the income) are indeed considered to be core aspects of what constitutes a ‘formal’ business. As for paying taxes, focus group participants were in general unable to explain the reasons behind the choice of regime (this contrasted with the relatively clear views on other issues). There appeared to be a limited understanding of the tax obligations under different tax regimes. What emerged was that in many cases, decisions regarding tax issues were delegated by the business owner to an accountant or some other person who is perceived to be better-informed than the business owner.
10. Having a RUC number is perceived to have some benefits, mainly through expanding the customer base and improving access to credit. In contrast with the negative view on the municipal license, the focus groups and interviews with micro and small businesses suggest that having a RUC number conveys concrete benefits. Having an RUC number is perceived to allow the business to grow its customer base because one can issue receipts and hence sell to formal businesses. A small furniture manufacturer put it simply: “some customers place large orders and demand a receipt” while another noted that “I was working with firms and needed to issue receipts, that’s why I got the RUC.” In addition, some interviewees perceive that having a RUC number improves access to credit and overall, the positive aspects of having a RUC number are deemed to outweigh the costs, which are mainly the perception of a greater monitoring by the tax authorities. The result that having a RUC number is perceived to have the benefit of attracting clients because of the ability to issue receipts finds support in the survey results (Figure 2.3).
|Figure 2.3: Benefits from having a RUC number and reasons not to have one |
|Percent of businesses |
|Main benefit of having a RUC number | |Main reason not to have a RUC number |
|(single answer) | |(single answer) |
|[pic] | |[pic] |
|Note: Other includes ‘to avoid bribes’, ‘to attract new clients’, and ‘none’. |
|Source: World Bank survey of micro and small businesses. |
11. The survey also provides information on the use of the different tax regimes available to micro and small businesses. Corporate income taxation is structured in a three-tier system: the general regime and two special regimes for MSMEs: the RUS and the RER. The simplified regime (RUS) is aimed mainly at natural persons. The RUS is a single tax (monotributo) that substitutes both the corporate income tax and the sales tax (Impuesto General a las Ventas, IGV). The RER does not replace one’s liability for IGV. The key features of these different regimes are provided in Table 2.5. An overview of tax regimes for small enterprises in Latin America is presented in Table A.1 in the annex.
Table 2.5: Overview of corporate income taxation
| |Simplified Regime |Special regime |General Regime |
| |RUS (Régimen Único Simplificado) |RER (Régimen Especial de la Renta)| |
|Rationale |Single tax (monotributo) that replaces both IGV|Simplified corporate income tax |Tax liability on |
| |and corporate income tax |but liable for VAT |net income |
|Can expenses be deducted |No |No |Yes |
|from corporate income? | | | |
|IGV liability? |Not liable. Cannot issue receipts (facturas) |Liable |Liable |
| |that generate IGV credit | | |
|Qualifying criteria | | | |
|Annual turnover |Maximum 360,000 Nuevos soles |Maximum 360,000 Nuevos soles |None |
|Assets |Maximum 70,000 Nuevos soles |Maximum 87,500 Nuevos soles |None |
|Legal entity restrictions |Only for natural persons (and very restricted |Natural persons and legal entities|All |
| |legal entities) | | |
|Type of activity |All, with some exceptions (e.g., transport, |All, with some exceptions (e.g., |All |
| |show business, notaries) |transport, construction, medical) | |
|Tax liability |Fixed monthly quota as follows: |1.5% of turnover for manufacturing|30% of net income |
| |Cate-gory |and commerce; | |
| |If gross monthly turnover (soles) |2.5% of turnover for services | |
| |and total monthly purchases (soles) | | |
| |Monthly quota (soles) | | |
| | | | |
| |1 | | |
| |< 5,000 | | |
| |< 5,000 | | |
| |20 | | |
| | | | |
| |2 | | |
| |< 8,000 | | |
| |< 8,000 | | |
| |50 | | |
| | | | |
| |3 | | |
| | ................
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