# _Understanding and linking incentives_

For the most part the policy discourse has focused on changes to the legal environment in which informal firms operate. But measures to reduce the costs of entry are unlikely to be sufficient in the absence of positive incentives or ‘carrots.’ Common sense suggests that linking these changes to access to other resources, such as training, finance and the provision of physical infrastructure may be even more effective. But the benefits of formalization are generally quite specific to each particular activity. In mining communities, for example, small scale artisans don’t usually require loans but they do require a reliable means of holding and transporting cash. Linking formalization to credit would make little sense but providing physical security might.<sup>4</sup> Small scale service providers, such as suppliers of electricity, sanitation and water, need a stable legal environment because they have to make fixed investments that can be easily expropriated. Their overriding concern is not infrastructure or accreditation for their products, but the legitimacy that comes with regular status.

What, if any, is the relationship among the different aspects of formalization? Formalization is a multi-faceted process and the linkages vary from country to country. In some middle income countries, for example, it may be necessary to obtain an external audit in order to tap certain forms of finance, particularly equity market. This can deter firms that are hiding activities from the tax authorities from seeking a public listing (Kenyon, 2006). In lower income countries on the other hand, there is typically no interface or information sharing between credit or land titling registries and the tax authorities. Nor is there necessarily any connection between product market upgrading and some other aspects of formalization. Moroccan firms wishing to participate in government sponsored export programs need to be registered, certainly, but they would not necessarily need to undergo an audit and might well continue to under-declare sales and workers to the tax authorities.<sup>5</sup> The evidence linking legal formalization to participation in markets is weak. A study of the impact of Peru’s administrative law reform, for instance, found that its benefits had fallen well short of what was promised.<sup>6</sup> Policymakers are often cautious about linking market access to registration or other bureaucratic requirements. They feel that markets should be open to all irrespective of status. And development practitioners, especially those in micro-finance, may be wary of linking formalization to access for finance for fear of undermining their business. There are also many cases in which such attempts have failed. In the late 1990s the South African government established education and training authorities to encourage SME development. The results have been inadequate for several reasons. Several authorities argued that they should prioritize the needs of formal firms since they were the ones paying the levies. Also many training providers regarded informal employees as untrainable because of their low literacy levels. Meanwhile, high levels of crime meant that

> 4 Interview with Lucie Philips, President, IBI.

> 5 Interview with Yasser Charafi, Projects Officer, IFC, Rabat, Morocco.

> 6 Of the 512,000 families that received land titles between 1996 and 2000, for example, only about one percent had obtained a mortgage from a bank – which had been the original rationale for reform (Winterberg, 2005, 4).

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