# **5. Why does formality matter?**

There are a number of potential reasons why formality has a positive impact on firm profits. The literature highlights several possible channels, including improved access to credit (Straub, 2005); ability to attract more customers by issuing receipts and lowering the costs of corruption (McKenzie and Sakho, 2010); ability to attract/retain qualified workers, opportunities to participate in government SME support programs, and access to contract enforcement mechanisms (Perry et al, 2007). In this section, we consider the role of some of these channels in enhancing firm profitability in Ecuador using the EMES data as well as the outcomes of the focus group discussions.

According to firm owners, the main benefit of formalizing is to “follow the rules.” As shown in Figure 9, more than 40 percent of respondents mention “following the rules” ( _estar en regla_ ) as the main motivation for complying with regulatory requirements.<sup>18</sup> Similar sentiments were also expressed during focus group discussions, especially with owners of larger businesses (more than 10 employees) who indicated that they could not imagine operating their firms without having taken some steps towards formality. More generally, firm owners of all sizes felt that in order to grow and compete successfully for larger contracts, “having everything in order” and “following the rules” is a necessity.

**Figure 9: Benefits of registering with tax authorities and the municipality**

<!-- Start of picture text --> Advantages of having a tax identification number (RUC) Advantages of having a municipal license<br>0 10 20 30 40 50 0 10 20 30 40 50<br>Follow the rules Follow the rules<br>Avoid fines<br>Avoid fines<br>Issue tax receipts<br>Ability to obtain RUC<br>Improve access to credit<br>None<br>Deduct VAT on purchases<br>Improve access to credit<br>Attract new clients<br>None Reduce bribes<br>Reduce bribes Attract new clients<br><!-- End of picture text --> _Source_ : Authors’ calculations with EMES data.

The next most commonly mentioned benefit of formality is to avoid costly fines. This reason was named by 24 to 34 percent of respondents (Figure 9), and was also brought up during the focus group discussions. However, the EMES data on the likelihood and amounts of fines does not provide much evidence to support this motivation. Among the 141 firms (out of total 1,221 surveyed), more formal firms are actually more likely to have paid a fine in the last year, although this could be because more formal firms are also more visible and therefore more likely to be visited by authorities. For those who did pay a fine, there is no relationship between formality and the amount of fine paid, either in absolute value or as a share of revenues or profits.

The third most mentioned benefit is the ability to issue tax receipts to customers. This reason was cited by more than 20 percent of firms with a tax identification number (RUC); in addition, almost 8 percent of 18 These questions were only asked of those business owners who have a RUC or a municipal license. Those who are not in compliance with these requirements were instead asked their reasons for not having done so.

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