Why Do Many Firms Start Informal Before Formalising a Few Years Later?

Why It Matters

Reducing informality can expand the tax base, improve resource allocation, and raise aggregate productivity, making it a critical lever for development policymakers in low‑income economies.

Key Takeaways

• 31% of Nigerian formal firms began informally
• Taxes and enforcement drive formalisation more than registration fees
• Halving profit taxes could cut informality by 39 percentage points
• Perfect enforcement reduces informality 69% without harming GDP
• Easing finance modestly lowers informality but boosts output significantly

Pulse Analysis

Informality remains a dominant feature of many sub‑Saharan economies, where entrepreneurs often lack collateral and face high financing barriers. By operating off the books, they avoid recurrent tax payments and can grow modestly before confronting stricter enforcement as size increases. This dynamic creates a two‑stage pathway: an initial informal phase to build assets, followed by formalisation once the marginal cost of staying informal outweighs the benefits. The pattern is especially pronounced in Nigeria, where one‑third of firms transition from informal to formal status, contributing a sizable share of employment in the MSME sector.

A recent structural analysis calibrated to Nigerian data quantifies how different policy levers reshape this transition. Cutting profit taxes by half slashes informality by 39 percentage points, spurring a 33 % jump in output and modest revenue gains. In contrast, a modest 10 % reduction in registration fees barely moves the needle, as general‑equilibrium effects offset initial gains. Perfect enforcement—eliminating detection risk—cuts informality by 69 % without depressing GDP, challenging the view that stricter policing inevitably harms production. Easing financial constraints for formal firms lowers informality by 6 percentage points while boosting output by 64 %, highlighting finance as a secondary but still valuable lever.

For policymakers, the evidence suggests that a balanced mix of tax reforms, targeted enforcement, and productivity‑enhancing initiatives can deliver the greatest gains. While aggressive enforcement raises compliance and revenue, it may face political resistance; tax reductions, though popular, risk revenue shortfalls if not paired with broader growth strategies. Incremental improvements in access to finance and investments in firm productivity can complement these measures, ensuring that formalisation translates into higher aggregate productivity and more robust public finances. Ultimately, treating informality as a dynamic choice rather than a static condition enables more nuanced, cost‑effective interventions that support inclusive economic development.