38373 WORLD BANK GROUP AFRICAREGION,PRIVATE SECTOR UNIT Summary of 2006 Urban Informal Sector Investment Climate Analysis in Kenya UGUSTA Informal employment contributes approximately 34% GNP in Kenya, and is increasing more than ten fold the 35 growth rate of the formal economy at just over 16%. This statistic clearly has several implications for Kenya's private sector. Informal enterprises are able to circumvent government regulation and avoid mandatory taxes and fees, yet they risk being punished if detected and often have restricted access to services. UMBERN This note summarizes the paper "Kenya: Urban Informal Sector Investment Climate Analysis". The paper TEO draws on the Investment Climate Surveys undertaken in Kenya in 2003 on formal manufacturing and in 2004 on N the urban informal sector in order to analyze the determinants of firm's decision to be formal. Productivity Trends in Kenya's Private Sector recent surveys clearly shows that the formal and partially formal respectively has a higher percentage of its workfor- Therecentempiricalanalysisof Kenyanfirm'sproductivity ce with at least secondary school education than partially highlightstheproductivitytrendsanddifferencesbetween formal and informal firms. What is most striking about informal (micro-level,non-registered)and partially formal the data is that on average a higher percentage of partially (micro level, registered) firms. Top performing partially formal firm's workforce has post-secondary school educa- formal garment firms are growing their sales, taken to be tion than a formal firm's workforce.The key to understan- a proxy for productivity, and outperforming the top per- ding this unexpected trend is the role of apprenticeships formers of the informal economy; however, in general the which due to their formalized nature are often categori- partially formal firms surveyed are performing worse than zed as post secondary education--Kenya has one of the (or equal) to their informal counterparts. more developed formal training systems in the region,and One of the important distinguishing factors in un- these programs tend to be engaged in the informal sector. derstanding this trend is to look at distinct groupings wi- The obvious ensuing question would be to ask why this thin the informal economy and recognize the important is the case. Another possible explanation is to look at the role of linkages to the formal economy. Those stellar per- difference in relative rather than absolute terms--the mi- formances by informal firms may be evidence of forward cro-sector (including informal and partially formal firms) links that the more entrepreneurial firms have established tends to consist of much smaller firms, and thus may by with the formal economy. In fact, selling to small busines- its very nature have a higher percentage of their workforce ses has a significant impact on firm sales both for informal with higher levels of education. firms and partially formal firms. This in turn impacts the Mostcrucially,thedatafoundthatovertime,informal prospects for growth of the firm and can signify that these firms tend to fail quicker than formal firms, and a lot of firms are capable,and ready,to formalize their business. them exit the sector or of course,graduate to partial or full Having a labor force with a sufficient level of educa- formal status, within a couple of years--formal firms ave- tion and technical know how is of the utmost importance rage near 30 years of age, partially formal firms are approx for any sector looking to grow. The size of a firm, or the factthatitisorisnotregistereddoesnotaltertheneedfor an educated workforce. Understanding how the informal *Between1991and1994theinformaleconomygrewby16.1%, and partially informal sectors compare with the formal compared with the formal economy, which only grew at 1.6% sector here can be informative. The data collected by the during that period. half of that, while informal firms are about a third as old as outweigh registration costs for a firm to choose to occupy formal firms. land. Crucially, the occupation of property is necessary to Different Perceptions of Key Constraints obtain infrastructure services. This is supported by the evi- to Enterprise Growth dencethatalowerpercentageof firmsthatoccupylandview infrastructure issues as binding constraints. Partially formal firms consistently rate each obstacle as a greater impediment to business than do informal firms, Infrastructure. The third benefit to formalization, and clo- with the exception of infrastructure and access to land. In- sely affiliated to access to land. It is therefore not surprising formal firms have two main concerns: they perceive finance thatinformalfirmsfeelinfrastructureconcernsmoreacutely and infrastructure as their main concerns--partially formal than others; 90 percent perceive both telephone and trans- firms are also seriously concerned by those constraints, but portationasbindingconstraintstogrowthandproductivity, alsorateeconomicpolicyuncertaintyandcustoms/tradere- while less than 50 percent of formal firms felt severely cons- gulations in their top five. Formal firms only share the cost trained. of finance as a top concern. Objectivedatareinforcesthesufferingof informalfirms By breaking down these constraints into benefits and and provides a good example of the benefits of formaliza- constraints to formalization we can understand these diffe- tion. Formal firms lose approximately 9.5 percent of sales rent perceptions and how they play out in a firm's decision value as a result of power supply interventions, already a to formalize, becoming closer to identifying types of inter- high value compared to the average in sub-Saharan Africa ventions for increasing formalization in Kenya. (6.1% 2004). But this is less than a third of what even par- tially formal firms have to endure. Alternative power sup- Benefits to formalization plies would provide some sort of mitigation for firms, but giventheoutlaysandapparentrestrictedaccesstofinancing, Finance.Access to and cost of finance were ranked as a"ma- this becomes somewhat of a cyclical dilemma for informal jor"or"very severe"constraint by more firms than any other firms--it is not surprising that whereas approximately 70 obstacletobusiness,andthisperceptionhascloselinkswith percent of formal firms own a generator, only 5 percent of formality.Lookingattheusageof financebytheformal,par- partially formal firms own their own and a mere 3 percent tially so and informal sectors can clarify the texture of this of informal firms. constraint.Less than 20 percent of informal firms and near- ly 30 percent of partially formal firms have ever had a loan, Business ­ Government Relations. It is self-evident that tending to rely on internal funds or familial ties--when as- informal firms,as they interact less with government,tend ked whether they had ever applied for a loan, over 50 per- not to have high expectation of government services and cent of formal firms responded positively, and 30 percent thus rate this as much a constraint.However,formal firms fewer have had to rely on internal funding alone.This detail do pay taxes and thus are more likely to expect services along side a more severe perception of access to credit as a that are available and efficient,hence the higher percentage binding constraint to informal firms,suggests that banks do of unsatisfactory responses--over 70 percent. The impor- not grant loans to non formal firms as frequently. tant point for policy makers to notice here is that poor Government services will serve only to reduce the benefit Land Access.The full sample of formal firms and more si- to formalization and thus decrease the likelihood that in- gnificantly grouped with them over 95 percent of partially formal or partially formal firms will make the decision to formalfirmsoccupyboththeirlandandbuildings.Looked formalize. at in relation to informal firms one can see huge divergen- Business-Government relations presents another in- ce--only 70 of these firms responded positively, and this teresting story. Ten percent more informal firms perceive itself may be inflated since many informal enterprises are regulations to be inconsistent than partially formal or for- home-based. If the informal firm is growing it will even- mal firms.Here at least it would seem that formal firms are tually need its own space, but one would expect that it is reaping the benefit of formality. It is not surprising that go- thenhardertoremaininformalintheeyesof Government. vernment officials feel less of a need to be consistent in their Firms will only register if the benefits outweigh the costs, interaction with informal firms, who have less entitlement thus land occupation must lead to expanded profits that and thus inclination to complaint. Costs of Formalization Figure 1. Percentage of firms perceiving taxes to be a "major" or "very severe obstacle to operations and growth Taxes.An obvious cost to formalization is the obligation to pay taxes,involving both pecuniary and administrative hea- dache for firms.This is reflected in the significant difference in perception of taxes,shown in the graph below. Asexpected,thedatashowsaclearcorrelationbetween formality and percentage of sales reported for tax purpo- ses. On average, formal firms report nearly 90 percent of their sales, whereas partially formal firms report closer to 55 percent, with informal firms reporting just 17 percent. Becoming formal would therefore have to overcome the real benefits of tax avoidance. costs just increases prices in the formal sector and decreases Corruption. Formal firms perceive corruption to be more overall employment. of a concern for growth than any other constraint. Objec- However,there are several policy options for the public tive data on informal payments to government clarifies this sector to motivate increased formalization, with differing relationship--the informal firm has to pay more payments weight on beneficiaries: to government on average,which can be classed as the price they pay for government services. However, since it is not · Improve recurring formal productivity factors including a registered it pays fewer taxes than the formal firm. The- strong financial system, quality physical infrastructure, refore it is not surprising that the formal firm begrudges and available land--formal firms benefit informal payments more, since they are effectively being · Reduce Recurring formal Costs such as taxes, corruption double charged. and regulations, both in terms of processes and fees-- formal and informal firms benefit Other costs. Not to mention the one-time cost of registra- · Reduce One-time Costs since registration represents tion, which according to the World Bank Group's Doing the most visible barrier to formalization. Reducing the Business data is significant in Kenya, ranking 93 of 155 complexity and fee will lower this barrier--informal countries surveyed, the regulatory costs of formalizing can firms benefit be significant, especially if the government collects past · Improve Recurring Informal Productivity Factors; provi- taxes.Informal firms do not bear the cost of regulations as- ding services to informal firms directly would positive sociated with labor,customs,safety,consumer protection or social implications for the poorest in Kenya, and may other regulations which can be significant. allow firms to expand, or at a minimum increase their productivity and income, but is a near time solution Conclusion and Policy Suggestions since it directly rewards informality and increases com- petition for formal firms.--informal firms benefit A large informal sector has implications both for the firm · Improve the Stability of the Investment climate through and Government. Increasing the formal economy provides good Governance and consistent policies so that firms a wider tax base,and thus theoretically at least allows lower feel able to make long term decisions.If experience tells taxesandincreasedpublicservices;acompletepictureof the a firm that Government is reliable, they may form ex- economyandhencemoreinformeddecisions;andtheappli- pectationsof apositivereturninthefutureandthusare cation of measured regulation that benefits the public good. more willing to formalise.--Formal and informal firms Formalization also means less wasted entrepreneurial spirit, benefit since a firm's untitled assets cannot be used as collateral to start or expand a firm, and so the business stays small and This note is part of a series of summaries of analytical work underproductive. Moreover, a low income means that there of the Africa Private Sector Development Unit. It is based is no capital to formalize. on the report"Kenya: Urban Informal Sector Investment Cli- Punishing informal firms has proved to have no posi- mate Analysis".Formoreinformation,visitthewebsitewww. tive effect on the firm's decision to formalize--raising their worldbank.org/afr/aft