_High priority:_ The social benefits of formalization are arguably greatest when the persistence of informality as a means of competitive advantage threatens to undermine the implicit bargain between state and formal enterprises. A series of McKinsey studies in the late 1990s found strong evidence that non-compliant enterprises were using tax and regulatory evasion as a means of competing unfairly with more productive formal enterprises (Palmade, 2005). There is a common assumption that all forms of regulation require adjustment to meet the needs of informal enterprises. But ‘focusing on the difficulties small and informal firms face in meeting the costs of ... standards distracts our attention from pursuing opportunities to rise to the occasion and meet these standards, rather than be exempt from them’ (Tendler, 2002, 6). The most encouraging stories are those in which informal firms have overcome the obstacles to participation in formal markets – often under the threat of more stringent enforcement.

_Low priority:_ Some have argued that informality is a natural state for very small enterprises and that the costs of exclusion only become apparent once the firm reaches a certain size. This is particularly relevant in many low income countries, where the predominant form of employment is self-employment. Examples include the very poor or seasonal workers who engage in income-generating activity as and when circumstances require (Citron, 2004, 114), or those engaged in subsistence agriculture. Some commentators have gone even further and argued that extra-legality is an appropriate and workable strategy; others have argued that what matters is improving the livelihoods of workers in the informal economy, not encouraging formalization (USAID, 2005, 22). Maloney makes a useful distinction between informal workers and those employed in micro-enterprises, whom he argues should be tolerated as akin to the voluntary small business sector in developed countries, and larger enterprises that are either wholly or partially outside the regulatory system (Maloney, 2006, 9).

# **Explaining Formalization: Beyond ‘Carrots’ and ‘Sticks’**

We take the ‘carrot’ and ‘stick’ approach as our starting point. It is commonly accepted that there are costs and benefits of participating in societal institutions. The remedy derived from this diagnosis is straightforward: to alter the calculus of costs and benefits by amending the legal regime to suit reality. This means simplifying business registration requirements; it may also involve creating appropriate legal categories for enterprises that do not fit into the existing framework. On the tax side, it may require a combination of simplified and more predictable tax regime and more effective enforcement (Engelschalk, 2005, 27). More generally, tackling regulatory evasion requires governments to pay more attention to detection and enforcement – on which they typically spend far less than their counterparts in developed countries. This analysis is largely uncontroversial. It is a commonplace that compliance depends on firms’ perceiving that it is in their self-interest. And there is a large empirical literature, some of it based on survey evidence, that the more individuals and firms perceive that they are receiving quality public services, the more willing they are to pay taxes.<sup>2</sup> But the required blend between ‘carrots’ and ‘sticks’ is likely to vary substantially from case to case. Among other things, we should expect it

> 2 See Hanousek and Palda, 2004, for an overview and discussion of the situation in transition economies.

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