The importance of the informal sector in West Africa

A surprising feature of the informal sector in West Africa is the existence of large, informal firms. This goes against the widely-held belief that informal firms are small, family-run enterprises. These small firms do exist. But they coexist with a smaller number of very large enterprises. Understanding this heterogeneity of the informal sector is crucial for designing appropriate policies. The existence of successful, large, informal firms is testimony to the entrepreneurial potential of West African economies. This dynamism is throttled, however, by weak business climates and lack of enforcement of regulations, which encourage and allow large informal operators to operate with near impunity. It also impacts the jobs picture in these countries. Governments should promote policies that assist small informal firms to improve productivity and raise incomes while enforcing fiscal and regulatory obligations for large informal actors.

In West Africa the informal sector accounts for approximately 50% of national output, over 80% of employment, and 90% of new jobs. Yet at present we know relatively little about this sector since, by definition, some or all aspects of informal economic activity are off the formal record.

How should informality be classified? Do informal firms behave differently from those in the formal sector? And, to what extent should governments seek to formalize informal firms as opposed to assisting firms that remain informal?

Large informal firms have a level of sales that would call for regular business taxes, but they pay the presumptive tax by massively underreporting sales to the fiscal authorities. In WAEMU countries, there are different tax regimes for formal and informal firms. Formal firms pay regular business taxes whereas informal firms are subject to a lump sum presumptive tax.
Informal firms satisfy most of the criteria for formality used by mainstream economists but their accounts substantially underreport sales. In other respects, they behave like their small counterparts, in that they mainly cluster in certain sectors such as commerce, handicrafts, and transport, which are characterized by their lack of technological sophistication and low capital-intensity.

Large informal firms also behave like small informal firms in less easily measurable aspects such as family-based organization and management. Typically, these firms start small and prosper under the leadership of a particularly talented, hard-working, and perhaps lucky entrepreneur, often with assistance from ethnic and religious trading groups.  As they grow, these firms almost always remain controlled by an individual owner and do not survive his or her death or incapacitation, as those in the line of succession are often unable to unite and resolve disagreements. These entrepreneurs, although very talented and hard-working, often have little formal education and lack modern managerial capacities.

The assets and liabilities of the firm and the owner are also often closely intertwined. While formal firms of the same size have distinct departments (production, sales, human resources, finance) and a transparent organizational structure, all the functions of large informal firms are usually managed by the owner. Apart from the owner and a few permanent employees (rarely more than five), the personnel of large informal firms are all temporary. Permanent employees are normally confined to an accountant, a chauffeur and/or a messenger.

Bookkeeping of large informal firms is usually outsourced to an informal accounting firm, while all medium-size formal firms have in-house accounting departments. As a result, accountants with minimal education do the books for a number of firms simultaneously, paid by the task for end-of-year reporting. It is common knowledge that most large informal firms engage in tax evasion. It is also widely believed that they benefit from acquiescence or even collusion with high government officials. Despite their size and political connections, however, large informal firms are vulnerable to government crackdowns because they follow practices of small informal firms yet are visible to the government and public opinion.

Relations between formal and informal firms are complex, with cases of both competition and cooperation. Many formal firms rely on informal distributors. Commerce and construction involve particularly developed ties where there is subcontracting between formal and informal operators.  In other areas, competition from informal firms, particularly importers, undermines formal producers and distributors.

The coexistence of large and small informal firms in Sub-Saharan Africa has important policy implications. Improvements in the business climate (reduced corruption, simplified government regulation and taxation, and better public services) are important for inducing both large and small informal firms to formalize and create more permanent jobs. In other respects, however, policy should differentiate between large and small firms.

As has been widely recognized, small informal firms should be assisted and nudged towards formal status gradually, given their weakness and their role as a safety net for the poor. More robust enforcement of fiscal and regulatory obligations should be directed at large informal firms, who remain informal by choice rather than necessity.

This article originally appeared on The World Bank’s Jobs and Development Blog. Publication does not imply endorsement of views by the World Economic Forum.

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Authors: Professor Ahmadou Aly Mbaye is the Dean of the Centre de Recherches Economiques Appliquées at the University Cheikh Anta Diop of Dakar. Nancy Claire Benjamin is a Senior Country Economist in the Macroeconomics and Fiscal Management Department of the World Bank Group. Stephen Golub is the Franklin and Betty Barr Professor of Economics at Swarthmore College.

Image: A view is seen of the Nigeria stock exchange building in the central business district in Lagos. REUTERS/Akintunde Akinleye.