Introduction

Report No. 43737-PE

PERU

Trajectories towards Formality

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Five less informal departments

Second five less informal departments

Third five less informal departments

Second five more informal departments

Five more informal departments

Legend

Five less informal departments

Second five less informal departments

Third five less informal departments

Second five more informal departments

Five more informal departments

Legend

JUNE 16, 2008

Poverty Reduction and Economic Management

Bolivia, Ecuador, Peru and Venezuela Country Management Unit

Latin America and the Caribbean Region

Document of the World Bank

Republic of Peru Fiscal Year

January 1 to December 31

Currency Equivalents

Currency Unit

1 US Dollar

=

=

Soles

S/. 2.85

Weights and Measures

Metric System

Abbreviations and Acronyms

AAAAnalytical and Advisory Activities

BCRPCentral Reserve Bank of Peru (Banco Central de Reserva del Perú)

BONOPYMETraining and technical assistance vouchers

CITCorporate Income Tax

CNCNational Competitiveness Council (advisory body to the PCM)

COFIDEDevelopment Financial Corporation (Corporación Financiera de Desarrollo SA)

COFOPRIComission to Formalize Informal Property (Comisión de Formalización de la Propiedad Informal)

CONFIEPPeruvian Private Business Association (Confederación Nacional de Instituciones Empresariales Privadas)

CONSUCODECouncil of State Procurement (Consejo Superior de Contrataciones y Adquisiciones del Estado)

CTSCompensation for time in service (compensación por tiempo de servicio)

DNMYPENational Directorate for Micro and Small Companies (Dirección Nacional de la Micro y Pequeña Empresa)

ENAHONational Household Survey (Encuesta Nacional de Hogares)

FIASForeign Investment Advisory Service

GDPGross Domestic Product

GOPGovernment of Peru

GNPGross National Product

ICAInvestment Climate Assessment

IDBInter-American Development Bank

IFCInternational Finance Corporation

IGVGeneral sales tax (Impuesto General a las Ventas)

ILOInternational Labor Organization

IMFInternational Monetary Fund

INDECOPINational Institute for Consumer and Intellectual Property Defense

INEINational Statistics Institute (Instituto Nacional de Estadística e Informática)

LACLatin America and Caribbean Region

MSEsMicro and Small Enterprises

MEFMinistry of Economy and Finance

METRMarginal Effective Tax Rate

MTPEMinistry of Labor and Employment Promotion (Ministerio del Trabajo y Promoción del Empleo)

MYPEsMicro and Small Enterprises (Micro y Pequeñas Empresas)

NRSNational Registry of Suppliers to the State (Registro Nacional de Proveedores)

OLSOrdinary Least Squares

PCMOffice of the Prime Minister (Presidencia del Consejo de Ministros)

PRODAMESelf-Employment and Micro enterprise Promotion Program (Programa de Autoempleo y Microempresa)

PRODUCEMinistry of Production (Ministerio de la Producción)

PROMPEXExport Promotion Agency (Comisión para la Promoción de Exportaciones)

PROMPYMEComission for Promotion of the Small and Micro Enterprise (Comisión para la Promoción de la Pequeña y Micro Empresa)

RERSpecial Tax Regime (Régimen Especial de la Renta)

RUCTax identification Lumber (Registro Único de Contribuyente)

RUSSimplified Single Regime (Régimen Unico

Simplificado)

SBSSuperintendency of Bank and Insurance (Superintendencia de Banca y Seguros)

SMEsSmall and Medium Enterprises

SUNARPNational Registry (Superintendencia Nacional de

Registros Públicos)

SUNATGovernment Tax Agency (Superintendencia

Nacional de Administración Tributaria)

UITIncome Tax Unit

VAT Value Added Tax

Vice President, LCR:Pamela Cox

Director, LCC6C:C. Felipe Jaramillo

Director, LCSPR:Marcelo Giugale

Sector Director, LCSPE:Rodrigo Chaves

Sector Leader, LCSPE:Carlos Silva-Jauregui

Task Team Leader:Oscar Calvo-Gonzalez /

Rossana Polastri

ACKNOWLEDGMENTS

This report was prepared by a team led by Oscar Calvo-Gonzalez (LCSPE) and Rossana Polastri (Senior Country Economist, LCSPE) under the overall supervision and guidance of Rodrigo Chaves (Sector Manager, LCSPE) and Carlos Siva-Jauregui (Lead Economist and Sector Leader, LCSPR). C. Felipe Jaramillo (Country Director, LCC6C) linked the team to the Bank’s overall strategy and steered them in that direction. Mauricio Carrizosa (Adviser, IEGCR) and Vicente Fretes-Cibils (IDB) provided initial guidance on the study.

The team also included Luis Barrantes (LCSPE), Sebastian James (CICRS), Jan Loeprick (CICKM), David McKenzie (Senior Economist, DECRG), Rashmi Shankar (LCSPE), and Rich Stern (Program Coordinator for Business Taxation, FIAS). Contributions were also received from Cesar Baldeon (CFOMR) and Gladys Triveño (Proexpansión). Ipsos APOYO Opinión y Mercado conducted the survey of micro and small businesses and CONECTA carried out the focus groups and in-depth interviews with micro and small entrepreneurs. Maria Ines Thorne provided valuable logistical and production support.

The peer reviewers for the report were Alvaro Escribano (Universidad Carlos III), Pablo Fajnzylber (Senior Economist, LCRCE), Luke Haggarty (General Manager, CLALA), Vincent Palmade (Lead Economist, AFTFP), and Jamele Rigolini (Economist, EASHD). The report also benefited from substantive comments from a variety of people during various stages of this project, including Jacqueline Coolidge (Lead Policy Investment Officer, CICAF), Gladys Lopez-Acevedo (Senior Economist, LCSPP), Juan Carlos Mendoza (Senior Financial Economist, LCSPF), and Ian Walker (Lead Social Protection Specialist, LCSHS).

The team received valuable guidance through meetings with various authorities. Important insights and contributions were gained through interviews with a wide variety of individuals and groups representing officials of the Peruvian Government, institutions, and private sector (micro and small) firms. Particular thanks to the entrepreneurs who generously granted us their time through numerous interviews. The team would like to thank the Peruvian authorities for their continued cooperation, especially the support of the Ministry of Economy and Finance (MEF), the Ministry of Labor (MTPE), the Ministry of Production (PRODUCE), the National Institute of Statistics (INEI), the Superintendence of Tax Administration (SUNAT), the Superintendence of Banks and Insurance (SBS), the National Council of Competitiveness (CNC), and the Central Bank of Reserve (BCRP).

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Trajectories towards Formality in Peru

Table of contents

9Executive summary and policy implications

191.Introduction

26Informality in the sectors selected for the survey

312.Determinants of informality

32A. Who is our source of information?

35B. What do micro and small business owners tell us?

61C. Econometric analysis of the determinants of informality

65D. Dynamics out of informality

693.The impact of informality

69A. Is informality a cause of low profitability?

73B. What is the impact of informality on access to credit?

78List of references

80Annex A.Measures of informality based on the ENAHO using different definitions

98Annex B.Econometric results on the choice of tax regime and determinants of tax inspections

103Annex C.Econometric results on the determinants of informality

104Annex D.The impact of informality – methodology and impact on profits and on access to credit

114Annex E.Trajectories towards formality

115Annex F.Database of sector-specific labor regulations - methodology

116Annex G.The Marginal Effective Tax Rate Methodology

125Annex H.Data for calculating the marginal effective tax rate

List of boxes

19Box 1: What do we mean by informality?

24Box 2: A dedicated survey to study informality in Peru

44Box 3: Understanding the incentives of tax regimes – the Marginal Effective Tax Rate of the different corporate income tax regimes in Peru

51Box 4: What do businesses know about the Special Labor Regime for micro firms?

56Box 5: Severance payments de jure and de facto

58Box 6: Sector-specific labor regulations and the prevalence of informality

65Box 7: Case studies – formality is also a ‘refuge’

List of tables

26Table 1.1: Measures of informality based on the household survey in the sectors selected for the survey and in the economy

32Table 2.1: Number of businesses surveyed

33Table 2.2: Selected informality characteristics of surveyed businesses

35Table 2.3: Benefits and costs of formalizing perceived by micro and small business owners

39Table 2.4: Reasons for not having a municipal license

41Table 2.5: Overview of corporate income taxation

47Table 2.6: Results from econometric analyses of the choice of tax regime

48Table 2.7: Definitions of micro and small enterprises in the labor code and correspondence with tax regulations

54Table 2.8: Business owners’ estimates of how common is for workers to earn less than the minimum wage and not being on the payroll

56Table 2.9: Reasons for self-employment

62Table 2.10: Variables that help predict having a municipal license and an RUC number

63Table 2.11: Variables that help predict having both a municipal license and an RUC number

67Table 2.12: Summary of steps towards formalization

72Table 3.1: Impact of different formality characteristics on firm profits

88Table A.1: Special fiscal regimens for small taxpayers in Latin America

88Table A.2: Regulatory labor burden in comparative perspective

89Table A.3: Main informality characteristics among surveyed businesses, by city

89Table A.4: Main informality characteristics among surveyed businesses, by sector

90Table A.5: Most important problem affecting micro and business owners

91Table A.6: Obstacles for micro and small businesses - detailed questionnaire

92Table A.7: Sales of micro and small businesses surveyed, by customer type and business size

92Table A.8: Elements of formality

93Table A.9: Factors affecting the choice of tax regime

94Table A.10: Participation in state-supported programs

95Table A.11: Key factors behind the decision not to have a license, by business size

95Table A.12: Knowledge of where to formalize

96Table A.13: Share of workers earning less than minimum wage, by business size

96Table A.14: Reasons for not paying the minimum wage, by business size

97Table A.15: Percent of workers not on the payroll, by business size

97Table A.16: Reasons for not having workers on payroll, by business size

98Table B.1: Choice of tax regime - probit regression

99Table B.2: Choice of tax regime - multinomial logit (general regime)

100Table B.3: Choice of tax regime - multinomial logit (RUS)

101Table B.4: Choice of tax regime - multinomial logit (RER)

102Table B.5: Probit regression on the determinants of tax inspections

105Table D.1: "Impact" of having an RUC on log profits

106Table D.2: "Impact" of having a municipal license on log profits

107Table D.3: OLS Regression of log profits on both municipal license and an RUC number

108Table D.4: Businesses with and without bank accounts

108Table D.5: Sources of finance among businesses that have borrowed in 2007 or 2006

109Table D.6: Use of credit to purchase inputs

110Table D.7: Sources of start-up capital

110Table D.8: Borrowing by sector

111Table D.9: Sources of finance for most recent loan

111Table D.10: Terms of loan (annual or monthly rates) by source of finance

112Table D.11: Average length of loan in months

112Table D.12: Home ownership - percent of entrepreneur owning their home

112Table D.13: Business taking credit cards and checks, percent

113Table D.14: Impact on getting a loan of having a license and RUC number

114Table E.1: Time lapsed from opening business to getting RUC number and municipal license

List of figures

21Figure 1.1: Informality in Peru and other countries in Latin America and the Caribbean

Figure 1.2: Informality by firm size, selected sectors and economy-wide27

Figure 1.3: Map of informality prevalence by region28

Figure 1.4: Informality prevalence by region and income per capita29

Figure 1.5: Informality rate and economic growth, 2003 to 200630

Figure 2.1: Share of surveyed businesses at different degrees of formality34

Figure 2.2: Benefits from having a municipal license and reasons not to have one38

Figure 2.3: Benefits from having an RUC number and reasons not to have one40

Figure 2.4: Distribution by turnover of businesses filing under different tax regimes43

Figure 2.5: Relationship between the number of workers and those with health coverage and pension50

Figure 2.6: Kernel distributions of monthly income for private salaried workers – Metropolitan Lima53

Figure 2.7: Minimum wage in Peru and selected countries in the region53

Figure 2.8: Informality prevalence for workers, by pay system (piece-rate or not)55

Figure 2.9: Formality characteristics among surveyed businesses, by age of business68

Figure 3.1: Difference in profitability between the business with a municipal license and those without70

Figure 3.2: Difference in profitability between the business with an RUC number and those without71

Figure 3.3: Financial depth73

Figure A.1: Calculating the productive definition of informality based on the ENAHO80

Figure A.2: Map of informality prevalence by region81

Figure A.3: Map of informality prevalence by region82

Figure A.4: Map of informality prevalence by region83

Figure A.5: Informality prevalence by region and income per capita84

Figure A.6: Informality prevalence by region and income per capita85

Figure A.7: Informality prevalence by region and income per capita86

Figure A.8: Informality rate and economic growth, 2003 to 200686

Figure A.9: Informality rate and economic growth, 2003 to 200687

Figure A.10: Informality rate and economic growth, 2003 to 200687

Executive summary and policy implications

Context

ES. 1. Informality in Peru is high compared to other countries in the Latin America and the Caribbean region. Measuring informality is notoriously difficult, in large part because informality is not easily defined. Alternative measures of informality include a so-called ‘productive’ definition focused on the characteristics of the productive unit and a ‘legalistic’ definition focused on the coverage of workers by mandated social protection. According to the so-called productive definition of informality, 76 percent of the economically active population in Peru is informal (the third highest share in the Latin America and the Caribbean region). Taking the legalistic definition of informality, around 86 percent of the economically active population lack access to a pension, 86 percent work without a contract, and 80 percent lack healthcare insurance. Peru reports the third-highest rate of informality in Latin America and the Caribbean as measured by the percent of workers without a contract and without health insurance, while Peru is in the middle of the table in the region with regard to access to a pension.

ES. 2. Addressing informality is a priority in the policy agenda of the Government of Peru. The Peruvian economy has enjoyed a relatively long period of stable and sustained growth. Poverty numbers are coming down and formal employment is picking up. However, informality is still prevalent and this raises questions about the sustainability of growth in the medium term. The country is investing efforts in access to larger markets through trade agreements and if micro and small firms find it difficult to remain formal due to an onerous state, little can be expected for them in this context. More broadly, informality means that most people are not covered by labor protections. Without a pension, the living standards in old age of many Peruvians are at risk. Without health insurance workers face significant risks to their livelihoods. President García himself referred in April 2008 to informality as the “slavery of the twenty-first century.” But informality also erodes the social contract between the population and the state, making the provision of public services more difficult by reducing the available revenue base. In addition, informality may have a negative impact on business performance – though the cross-country evidence is mixed. It is in this context that the Government of Peru has set the goal of reducing informality by one-third by 2011.

ES. 3. This study is timely, as the authorities’ interest in analyses of informality has increased. This report is the outcome of very close cooperation with the authorities of the Government of Peru. The authorities have been involved in all stages of the process, going back to the first phase of this programmatic study. The authorities proved instrumental in helping design the focus of this report, including the scope of a survey of businesses conducted for this study, the survey questionnaire itself, they also suggested specific topics to be explored – which are presented throughout the report mainly in the form of boxes.

ES. 4. ‘Formality’ is better understood as having different dimensions. In this report we explore four of those dimensions: business licensing, tax, labor relations and pensions, and business incorporation. It is well known that informality is not a straightforward concept. As a result, it is not easy to agree on a single definition of informality or to measure it easily. The important conclusion to draw from this is that informality can be better understood as being a multi-dimensional concept. In this report we take a pragmatic approach by exploring four dimensions of ‘formality’: business licensing, tax, labor relations and pensions, and business incorporation. Of course, a business person can legally operate with only service providers and no employees; or as a natural person and not a business with a separate legal entity. However, the choice of these aspects of what ‘formality’ may be stems from the result of focus groups with micro and small business owners – these are the very issues they have in mind when they think of ‘formality.’

ES. 5. This report focuses on the trajectories towards formality of micro and small businesses, drawing insight by polling those businesses directly. For the purpose of this report, micro businesses are those with up to 10 workers and small businesses those with 11 to 50 workers. This working definition is a practical choice that also reflects the criteria regarding maximum number of workers in the existing Peruvian legislation. It also helped us to design a dedicated survey of 802 micro and small businesses conducted for this study. Informality is widespread across all sectors of the economy and affects all types of firms but it is particularly high among small businesses. Drawing from the day-to-day experiences of micro and small businesses is at the core of this report. The analysis adds value to the authorities’ information set by presenting new evidence on what are the most critical steps in the formalization process and what are the key considerations at those junctures. By focusing on practices and decision-making of businesses, this report complements the analysis of labor market and labor legislation that was a key part of the first phase of the programmatic study.

ES. 6. Informality represents not only the exclusion of many workers but also reflects a decision by economic agents to exit the formal sphere. The approach followed here is informed by the analytical work for the World Bank’s Informality. Exit and Exclusion flagship report of the Latin American and Caribbean Vice-Presidency of the World Bank in 2007. In particular, this approach recognizes that informality not only undermines the social contract but is also a consequence of the limited value for the population of the services provided by the state. In other words, informality results also from decisions of economic agents about the optimal level of engagement with the state. Micro and small entrepreneurs use implicit cost-benefit analysis as to whether to remain informal or to formalize. Digging deeper into those choices and cost-benefit considerations is the subject of this report.

Main findings

The study finds no significant impact of certain characteristics of formality, such as having a municipal license or being registered with the tax authorities, on the profitability of businesses or on their probability of obtaining a loan. These results must be accompanied, however, by the caveat that establishing the impact of informality econometrically is notoriously difficult. The methodology used in this report does not attempt to capture the negative effects that informality may have on the performance of formal firms, or the effects that informality may have in undermining social trust and the overall business environment.

The study also finds informality to be particularly persistent in the area of labor relations and access to pension, driven largely by high costs of being formal, limited enforcement of labor relations, and a preference for flexible labor relations.

These two findings combined suggest that: (i) efforts to increase the access to health insurance and pension coverage of workers through a shift from informal arrangements to existing formal labor relations will prove difficult; and (ii) alternative methods to increase access to health and pension coverage are well-worth exploring. The rest of these main findings concentrate on the conclusions of the study regarding the determinants of informality and what prompts businesses to move towards formality.

ES. 7. What is an informal business? Micro and small entrepreneurs consider themselves to be formal if they pay (some) taxes, have a tax ID number and a municipal business license. Micro and small business owners do not typically consider that not having workers on the payroll is being informal. At some level business owners know that having workers on the payroll is mandated by law but the practice of not doing so is so widespread that it does not register with them as an informal practice. This implicit definition shared by micro and small entrepreneurs of what makes a business formal or informal is an important starting point. It helps to identify that any policy aimed at formalization of labor relations (or any aspect absent from the implicit definition) will face key communication and enforcement challenges.

ES. 8. As businesses grow they tend to become more formal – but not in the area of labor relations. The first step of formalization among micro and small businesses is to obtain a tax ID number (Registro Único de Contribuyente, RUC) and a municipal license. Most of these businesses pay taxes on some of their actual income. As micro and small businesses grow businesses consider incorporating the business into a separate legal entity with limited liability. However, at the same time informal labor relations persist even as the business grows. Businesses with 11 to 50 workers display a very complex mix of labor relations among their workers. But these complex relations are largely informal even among the core group of stable workers.

ES. 9. The trajectory of businesses towards formality is driven by how the costs and benefits across different dimensions of informality change as the business grows. The study draws on both a quantitative survey of 802 micro and small businesses as well as on qualitative data gathered from seven focus groups, interviews, and case-studies. Overall, the different sources of evidence presented in this study present a consistent pattern of how micro and small entrepreneurs make their choices regarding whether to cross into formality or to remain informal. This pattern, which we now discuss in more detail, can be characterized in broad terms as reflecting largely the costs and benefits faced by business owners. At the same time, some evidence was also found that certain behaviors may be partly explained by a persistent ‘culture of informality’ by which micro and small businesses would remain informal simply because this is the societal norm.

ES. 10. In many cases, the main driver behind the formalization process is the fact that enforcement makes it costly to remain informal. In the areas of business licensing and paying taxes the costs of remaining informal increase notably as the business grows. Enforcement is the critical factor affecting the decision to obtain a municipal license which otherwise is seen as conferring no benefits to the business. In addition, businesses perceive the process to get a municipal license as unnecessarily burdensome and arbitrary. Thus, micro and small businesses exploit any opportunity to avoid compliance. Businesses are less likely to get the municipal license if they operate in sectors such as textiles because they can operate workshops without being detected. In some cases, businesses prefer to pay off inspectors rather than obtain the license, but as the business grows so also does the number of visits by inspectors, thus making the strategy of paying them off not worthwhile, most businesses end up obtaining a municipal license.

ES. 11. Businesses perceive benefits from formalizing only in the area of paying taxes and business incorporation. While enforcement of taxes is a key factor in ensuring compliance, businesses do see benefits in being registered with the tax authorities and regularly paying taxes (at least on some of their actual income). Benefits from formalizing in the area of paying taxes include an expanded client base since the business can issue receipts and can therefore sell to larger clients that require receipts and also to the state. In addition, there is some limited evidence to show that being registered with the tax authority and in a position to show regular payment of taxes may improve access to credit. The analysis also suggested that incorporating the business may be an important step in the formalization process. Micro and small business owners consider that incorporating the business under a separate legal entity with limited liability provides not only a way to preserve the individual patrimony but also business opportunities as the business gains credibility in the marketplace.

ES. 12. But the existing tax regimes may need to be fine-tuned as they currently do not encourage formalization. This applies when special tax regimes do not encourage micro and small businesses to move to the general regime as they grow and to incorporate as separate legal entities. Few businesses choose to file taxes under the special regime for corporate income tax (Régimen Especial de la Renta, RER). Instead businesses prefer to remain under the much simpler, but more onerous, simplified regime (Régimen Único Simplificado, RUS) or the general regime – despite the fact that the latter imposes the full set of requirements designed for larger enterprises. These filing patterns suggest that compliance costs may be high under the RER – discouraging businesses from moving from the RUS to the RER. In addition, the constraint under the simplified tax regime (RUS) by which most legal entities are prevented from filing taxes under that regime, may result in businesses choosing to remain operating as natural persons for longer than they otherwise would, which may have a negative impact in business access to credit and market opportunities. Overall, current practices contrast with the goal of having small businesses under the special regimes and larger businesses under the general regime.

ES. 13. In the absence of enforcement, businesses keep informal labor relations and explain them partly on the grounds of a need for greater flexibility. The very fact that businesses do not consider this an aspect of informality is indicative of how prevalent it is. Based on the survey conducted for this study more than 80 percent of micro and small businesses have no workers with a contract. This high number is unsurprising given what we know from the household survey about the economically active population in Peru (again around 80 percent of the labor force without a pension). What is more remarkable is that the proportion of businesses with no workers on the payroll decreases only slightly among businesses with 11 to 50 workers, of which approximately two-thirds have no workers on their payrolls. As for the reasons why labor relations are so informal, the analysis from the focus groups suggested that in part this stems from a need to keep flexible labor relations in what is a rapidly changing and highly cyclical marketplace. While this may be true for smaller businesses, this reason is also claimed among larger businesses of 11 to 50 workers, which typically have a stable group of core workers yet often those core workers are still reported to be service providers who simply issue receipts for their services (recibos por honorarios).

ES. 14. Micro entrepreneurs claim that the minimum wage and holiday pay impose not only a high burden but are also hard to reconcile with their preference for piece-rate pay arrangements. In some cases the foremost concern of micro and small business owners with the formal requirements regarding minimum wage and holiday pay does not appears to be their level but the fact that they perceive it to be in opposition to the piece-rate pay arrangement (destajo). Micro entrepreneurs are often confused when it is suggested that a minimum wage could be paid as a floor for their workers’ salaries. This perception is all the more puzzling given the complex mix of labor arrangements that micro and small businesses actually have. One interpretation of this finding is that minimum wages would be in fact binding for a large proportion of the workforce (for more than half of the workforce if the survey results are taken at face value). Hence the minimum wage may truly have the disincentive effects on effort that micro entrepreneurs fear. The survey conducted for this study provides some supportive evidence that two-thirds of all businesses surveyed consider that their business is not productive enough to allow paying the minimum wage. At the same time, the survey also provides evidence that there is a group of workers who earn more than the minimum wage but who are not on the payroll, for which the preference for piece-rate pay arrangements (on the side of the employer) and for higher take-home pay instead of benefits (on the part of the worker) seems to play a role.

ES. 15. Firing costs are also perceived to be high and a deterrent to include workers on the payrolls. Most micro and small entrepreneurs consider that the compensation that workers receive upon been fired is not only too high but also a more important factor than the actual wage to be paid in explaining why workers are not on the payroll. Firing is also perceived to be complicated and the process prone to legal disputes and costs. In this regard, and somewhat paradoxically, there may be an incentive to incorporate the business into a legal separate entity as a way to protect the entrepreneur from labor-related litigation. In addition to the level of firing costs, the study uncovered evidence that the de facto severance payments differ considerably from the de jure severance payments. To the extent that this results in increased uncertainty about the true costs of firing, this may further discourage the formalization of labor relations.

ES. 16. Overall, micro and small business owners have limited information about the regulatory frameworks affecting them. Most notably, the Special Labor Regime, which provides for a much reduced burden of social benefits on the part of the employer, is virtually unknown among micro and small entrepreneurs. The limited knowledge of the Special Labor Regime for micro businesses highlights the communication challenges implied in addressing the issue of labor informality. In addition, there is limited information among micro and small entrepreneurs about the new regulatory framework for municipal business licensing. The interaction between the entrepreneur and the state is also made more difficult by the existence of different definitions of what constitutes a micro or a small business for tax and labor purposes and, more importantly, the fact that those definitions overlap only partially with each other.

ES. 17. Micro and small businesses typically obtain information about the costs and benefits from their peers or from an accountant to formalize their business. This finding, which emanated from the qualitative research conducted for this study, helps to explain why, for example, factors such as owner education do not affect the choice of tax regime. The choice of tax regime is effectively not made by the owner but by the accountant. This qualitative research suggests that a similar pattern may also affect other decisions to formalize, particularly the decision to incorporate the business as a separate legal entity.

Policy implications

The following conclusions are meant to serve as input for the ongoing policy dialogue with the authorities of the Government of Peru (GOP). Policy implications that can be implemented in a relatively shorter time-frame will be discussed here first, followed by those that will pose greater challenges to implement.

‘Quick-wins’

ES. 18. Unify the definition of a micro and small enterprise for tax and labor purposes. While there is no standard international practice for what the criteria should be to consider a business to be a micro and small enterprise (MSE), the guiding principle should be one of clarity. The preferred solution is to have a single definition agreed by all different ministries and applied consistently. Alternatively, the number of criteria that a business has to meet to qualify under the different regulations could be reduced. One possibility would be to define eligibility for certain tax regimes on the basis of turnover and to define eligibility for the special labor regime on the basis of the number of employees. The decision to include additional criteria as a way of preventing certain businesses from ‘getting through’ under a more simple framework (e.g., a capital-intensive and high-turnover business with few employees would qualify for the special labor regime) ought to be carefully weighed against the disincentive that complexity and partially overlapping criteria pose to formalization.

ES. 19. Eliminate the register of eligible suppliers to the state in order to expand the benefits of formalization. Peru mandates that 40 percent of all state purchases to be sourced from MSEs. In practice less than 20 percent of purchases are sourced from MSEs. In part, the effectiveness of this legal requirement is weakened by the additional bureaucratic and cost burden that MSEs have to face in order to compete for state contracts, as all businesses wanting to supply the state have to pay to be registered on a list of eligible providers. A way to reduce the bureaucratic burden on micro and small business would be to eliminate the register of eligible suppliers, establishing that all formal businesses (e.g., those with a RUC number) are eligible to bid in public procurement tenders by default. If necessary the GOP could replace the register of eligible suppliers with a listing of ineligible suppliers: those fined by SUNAT or the Ministry of Labor. This change would have some impact on expanding the benefits of formalization without unduly compromising the integrity of the system since the register of eligible suppliers does not carry inspections. Overall, improved market access must be emphasized as a key benefit of formalization, given that micro and small business owners already perceive this a benefit of formalizing in terms of paying taxes and of business incorporation.

ES. 20. Continue with simplification efforts in municipal business licensing. In Lima the Tramifácil project, with support from the IFC, reduced the time to obtain a license from a month to a week and cut the number of procedures from 33 to five. Such efforts are being expanded across an increasing number of municipalities and are expected to alleviate somewhat the concerns of micro and small business owners regarding the bureaucratic burden posed by municipal business licensing. To ensure that the costs of the municipal license remain affordable, municipalities need to ensure that, as provided by the regulatory framework, the fees charged to businesses reflect only cost recovery considerations. The cost of the municipal license in 2007 ranged from 1.7 percent of per capita GDP in Lima to 9.7 percent of per capita GDP in Huancayo. These figures are relatively high compared to a selection of 65 municipalities in the Latin America and the Caribbean region monitored by the IFC Municipal Scorecard, in fact Huancayo was the lowest ranked municipality of all 65, and Lima, while being the highest ranked in Peru, was only the nineteenth of the regional sample.

ES. 21. Review the costs of complying with the different tax regimes to identify ways to reduce them, and re-calibrate the simplified and special tax regimes. Costs of complying with the requirements in the different tax regimes may be a significant factor affecting the choice of tax regime under which businesses are filing their taxes. However, more analysis is needed as the drivers of the choice of tax regime remain unclear. The restriction that only natural persons can file under the simplified regime: RUS, may discourage businesses from incorporating into separate legal entities, this study suggests that this is an important step in the formalization process.

ES. 22. Step up communication efforts, possibly in partnership with associations of accountants, those who are close to the micro and small entrepreneurs. The finding that micro and small entrepreneurs often based their decisions to formalize on the information they gather from other MSEs poses a challenge for effectively communicating with them. However, the finding that MSEs also rely heavily on the accountant that files their taxes opens up an opportunity for the GOP to partner with associations of accountants to improve the effectiveness of efforts to relay relevant information, such as that regarding the labor regime available to micro enterprises.

ES. 23. Target businesses that already participate in some state programs (purchases, etc) to provide information relevant to those businesses. An additional opportunity to improve the reach of information to MSEs is to make the most of the fact that some MSEs are already in contact with the state through participation in a number of state-sponsored programs. Yet the survey evidence suggests that even among these MSEs knowledge of the Special Labor Regime was poor. The GOP may therefore want to explore making use of the opportunity to be in contact with the MSEs to introduce this information and to present options like the Special Labor Regime as an opportunity to reduce costs compared to the general labor regime. An additional point of contact with the MSEs would be through the SUNAT, though this is likely to be a less efficient way to relay information since the set of businesses dealing the state-sponsored programs is in effect a self-selected group. For municipalities to efficiently perform as a link in the relays of information, an even bigger effort would be required given the still broadly negative view that micro and small entrepreneurs have of the municipalities.

Longer-term challenges

ES. 24. Consider ways to expand access to health care insurance and pensions that do not necessarily involve including workers in the general labor regime. Given the intrinsic difficulties in establishing the link between informality and business performance measures, the econometric results presented in this study must be interpreted with great caution. However, they suggest that the key negative aspects of informality relate to the lack of social protection of workers. Given the tough hurdles that need to be overcome to make the labor regulatory environment more conducive to the expansion of formal employment in MSEs (see challenges below), it seems worthwhile to explore the feasibility of broad access schemes that will help expand health care insurance and pension coverage. In exploring policy options the potential impact of reforms on the incentives to contribute under the existing system needs to be carefully examined. A particular concern to bear in mind is that super-imposing non-contributory programs on top of a contributory system may actually create incentives for informality.

ES. 25. Alleviate the burden of labor regulations on micro and small businesses, especially regarding social benefits and firing costs. The burden of labor regulation in Peru is among the highest in Latin America, as the first phase of this study documented. For example, in the Doing Business indicators 2008, Peru had a difficulty of hiring index of 44 (compared to 37 for the region on average). The new evidence uncovered in preparation of this second phase provides further support to the conclusion that labor regulations remain a barrier to formalization. The evidence compiled for this study suggests that benefits such as holiday pay and high firing costs are perceived to be among the most important factors which deter businesses from including workers in their payrolls. In addition, severance payments that workers receive de facto are substantially (and somewhat unpredictably) lower than what workers are entitled to de jure. This adds to the uncertainty about what the actual firing costs may turn out to be, and hence firing costs and procedures may act as a deterrent to formal employment. Reducing firing costs to bring them in line with the average de facto severance payments would reduce uncertainty. An important caveat, however, applies to the case of micro businesses since most of these entrepreneurs do not know about the reduced benefits and firing costs that the Special Labor Regime for micro businesses allows. Expanding the coverage of this special regime to larger businesses may provide an alternative, though crucially reform efforts would be in vain if information failed to reach the MSEs.

ES. 26. Consider ways to improve the minimum wage regime so that they become less of a binding constraint, including considering the appropriateness of region-specific minimum wage rates. The survey of micro and small businesses conducted for this study provides evidence that the minimum wage is perceived to be as too high, especially for the smaller businesses. In fact, the statutory minimum wage is slightly below the median wage for the economy as a whole. The level of the minimum wage ranks high for businesses among the reasons why workers are not paid the minimum wage. More than 70 percent of businesses with 1 to 5 workers consider that their business is not productive enough to pay the minimum wage to workers. This proportion is lower for larger businesses but even of those with 11 to 50 workers, more than half of surveyed businesses consider that they are not profitable enough to pay the minimum wage to workers.

ES. 27. Once an adequate regulatory labor regime is in place it is important to enforce it firmly and consistently. The combination of weak enforcement and overly strong de jure labor regulations may undermine the rule of law and cultivate a social norm of non-compliance. This calls for improvements in the regulatory regime, as noted above. It also calls for a more effective enforcement once an adequate regime is in place. The role of weak enforcement was also highlighted by the results of the survey. The finding that the share of workers outside the payroll is higher than the share of workers earning the minimum wage indicates that there are workers for which the minimum wage is not the binding constraint impeding formalization. In turn, this finding suggests that opportunistic behavior may be a driving force of labor informality, at least for some workers. Moreover, the analysis found some support for the role of labor inspection rates in affecting the probability of a business to employ workers under formal labor relations. Improving the enforcement of labor laws will likely require an increase in resources given the number of inspectors that the Ministry of Labor (MTPE) currently has at its disposal. In this regard, the addition of 104 new labor inspectors to the MTPE, bringing the total to 450, brought the number of inspectors to around 1 per 40,000 members of the economically active population. This is still a low figure as Peru would need approximately three times as many inspectors to reach the benchmark suggested by ILO (2006) for industrializing countries of 1 inspector per 15,000 workers. Peru would still need to almost double its number of inspector to reach the ratios observed in Argentina, Brazil, or Chile, all of which have ratios of 1 inspector per 20,000 to 25,000 workers.

1. Introduction

1.1 This report, the second part of a programmatic study, focuses on the trajectories of Peruvian businesses towards formality. This is the second phase of a programmatic study on informality in Peru the objective of which is to analyze the causes and effects of informality so as to provide policy options for a reform agenda. The first phase took stock of the characteristics of informality, and focused on how the labor market and labor legislation in Peru may be associated with informality (World Bank, 2007a). While the first phase of the study noted strong incentives to remain informal, particularly due to labor and tax codes, it also argued the need to better understand the businesses’ perspective on the costs and benefits of informality and to map the steps that businesses need to take towards formalization.

1.2 ‘Formality’ is better understood as having different dimensions. It is well known that informality is not a straightforward concept (Box 1). As a result, it is not easy to agree on a single definition of informality or to measure it easily. The important conclusion to draw from this is that informality can be better understood as being a multi-dimensional concept covering areas such as business licensing, tax, labor relations, and (as discussed below) also business incorporation. The focus of this study is to document the trajectories of businesses towards formality along these different dimensions. The interest in the trajectories towards formality is rooted in the fact that, regardless of their size, most businesses have some characteristics that are to a degree informal. Hence, answers to questions about which dimensions of formality are achieved first, and why, can help the policy discussion on how to reduce different aspects of informality.

Box 1: What do we mean by informality?

The term informality means different things to different people. Some are concerned about workers not enjoying the protection of existing labor laws, with the corresponding impact on equity and welfare. Others are concerned about efficiency and productivity, as informality is seen as being associated with firms that are too small. Informality is also a source of concern for those who see it as eroding the legitimacy of public institutions and as suggestive of poor policy regimes. Reflecting in part these different concerns, multiple measures of informality have been advanced in the literature, commonly classified in two broad groups:

(i) The productive definition of informality, which focuses on the characteristics of the productive unit. One such productive measure of informality is the one traditionally used by the International Labor Organization, which defined the informal sector as economic units “with scarce or even no capital, using primitive technologies and unskilled labor, and then with low productivity” (ILO 1991). To make this definition operational, it is common to assume that the self-employed, family units, and micro-entrepreneurs and their employees fit under the description of activities with low capital and low productivity and are therefore considered to represent informal employment.

(ii) The legalistic definition of informality, which focuses on coverage of workers by mandated social protections. A common example of a measure of informality inspired by the legalistic definition of informality is to consider that a worker without rights to a pension is an informal worker. This approach has the advantage of recognizing that informal employment can be found in firms of all sizes and in all sectors of the economy. It is particularly useful in the case of Peru since participation in the state pension system is mandatory for all workers on the payroll of a firm (strictly speaking, this participation is optional for workers under the special labor regime for micro firms with less than 10 employees, but participation in this regime is limited to only around thirty thousand micro firms, see Box 4).

Informality covers many aspects, and in practice many indicators of informality are widely applied. While helpful, the use of other proxies creates the potential for ambiguity in the meaning of: ‘informality’. To that end, we will now make clear which proxy measure we are using for informality.

This box draws from Chapter 1 of World Bank (2007b).

1.3 In this report we explore four of those dimensions of formality: business licensing, tax, labor relations and pensions, and business incorporation. In this report we take a pragmatic approach by exploring four dimensions of ‘formality’: business licensing, tax, labor relations and pensions, and business incorporation. Some of these dimensions are more easily understood as referring to the formality-informality divide: to be formal a business has to comply with business licensing requirements and pay the required taxes. Regarding labor relations, an entrepreneur could in principle have no employees on the payroll and still be in full compliance with the law, as it is possible to pay for services through a contractual relation that is not of an employment nature. However, such a situation goes against the spirit of the labor protection legislation and, in the legalistic definition of informality, is typically considered to be one of the dimensions of informality. Finally, the report also considers one more dimension of formality: the incorporation of a business as a separate legal entity. A business person can legally operate as a natural person. But, as will be shown below, entrepreneurs themselves consider this an important aspect of the formalization process. It is also worth stressing that this report is not only concerned with illegal economic activity, which by definition, cannot be conducted in a formal way.

1.4 The report has been designed and prepared in close cooperation with the authorities to help draw implications for the Government’s priority of reducing the size of the informal sector. This suggests that there is much to gain from a detailed analysis of what is formal and informal at different stages of the development of a business. Documenting the reasons why and when a business chooses to formalize and the reasons why it may do so with regard to one facet of informality (say tax) but not another (say labor) is of interest to Government authorities as they consider policies that will help increase the speed with which businesses traverse the trajectories toward formality. It is also an area where, as identified in the first phase of the study and the in concept stage of this report, the World Bank can add value to the existing literature on informality in Peru.

Figure 1.1: Informality in Peru and other countries in Latin America and the Caribbean

Percent of workers that are informal, according to different definitions

Informal workers (productive definition)

0

20

40

60

80

100

Haiti

Bolivia

Peru

Paraguay

Guatemala

Ecuador

Nicaragua

Honduras

Colombia

Jamaica

El Salvador

Brazil

Mexico

Venezuela

Dominican Rep.

Panama

Argentina

Uruguay

Costa Rica

Chile

Workers without a pension

0

20

40

60

80

100

Colombia

Guatemala

Bolivia

El

Salvador*

Uruguay

Paraguay

Brazil

Peru

Argentina*

Nicaragua

Chile

Venezuela*

Mexico*

Ecuador

Workers without health insurance

0

20

40

60

80

100

Haiti

Ecuador

Peru

Paraguay

Nicaragua

Guatemala

Jamaica

El Salvador

Argentina

Mexico

Venezuela

Colombia

Costa Rica

Chile

Workers without a contract

0

20

40

60

80

100

Nicaragua

El Salvador

Peru

Guatemala

Ecuador

Bolivia

Dominican

Rep.Mexico

Panama

Chile

Note: Data for different countries do not all refer to the same year. * Refers only to salaried workers.

Source: Gasparini and Tornarolli (2006) and ENAHO (2006) for Peru.

1.5 The interest of the authorities in understanding the trajectories towards formality stems from their development objective of reducing informality. The Peruvian authorities’ interest is high compared to other countries in Latin America and the Caribbean according to some measures (Figure 1.1). The Government has a formally stated goal of reducing informality by one-third by 2011. Most recently in April 2008 President García referred to informality as the “slavery of the twenty-first century” and stressed that, without access to a pension, the living standards in old age of many Peruvians are at risk.

1.6 The first phase of the study raised a number of questions about informality in Peru that required additional data and further analysis. In broad terms, the first phase of the study argued that informality is driven by: (i) strong incentives to remain informal, particularly related to the high cost of labor and tax codes; (ii) bureaucratic obstacles to formalization; (iii) insufficient incentives to become formal, including greater access to credit, markets, and government-funded business services, combined with enforcement and penalties for those who do not formalize; (iv) a pervasive “culture of informality” that encourages regulation evasion; and (v) a frequently-changing array of laws and regulations which inhibits long-range planning and acts as a disincentive to formality. However, the first phase of the study also noted that it was often not possible to identify which factors were most critical given the limited availability of data.

1.7 The path towards formality reflects the choices made by businesses to stay informal or to formalize. This report explores why and how firms make those choices. Regardless of the measure with which one proxies informality, a common thread is the fact that informality reflects a lack of compliance with legal norms. This raises the question as to why agents are not in compliance with the law. The answer to this question has often been framed in terms of the exclusion of workers, which are involuntarily left outside formal institutions and are also without the protections given to formal workers. However, a second view emphasizes that there is an exit dimension to the actions of agents, by which firms and workers may simply opt into informality not finding any net benefit of interacting with the state (World Bank 2007b). A key objective of this report is to contribute to a better understanding of this exit dimension of informality in Peru from the perspective of the small business owner or self-employed person. To do so the World Bank has gathered new firm-level data to complement existing information.

1.8 To this end, this report provides new business-level evidence on the determinants of informality in Peru. The main value added of this study is to draw from new business-level data to shed light on the determinants of informality in Peru and in the policy debate. Therefore, the focus throughout the text will be to present and analyze this new information. Design and analysis of the research has been greatly influenced by recent efforts to explain the phenomenon of informality in Latin America, most notably the World Bank’s Informality. Exit and Exclusion flagship report of the Latin American and Caribbean Vice-Presidency (World Bank, 2007b). For the sake of brevity, references to broader regional trends and to theoretical considerations are kept to a minimum throughout the text. The interested reader is referred to the flagship report for a broader context and for a discussion of theoretical issues. For an international perspective on informality in Peru the reader is referred to the report produced during the first phase of this programmatic study.

1.9 By focusing on business-level data the report helps to fill a gap in the literature. As noted in the first phase of this programmatic study there are only a limited number of studies that address the determinants of informality in Peru using business-level information. Jaramillo (2004) asked a sample of firms in the garment industry in Lima for the reasons that explained their decision to become formal: 85 percent answered access to more suppliers and customers; 70 percent answered access to credit from a formal source; 63 percent to avoid the payment of fines and 40 percent to avoid the payment of bribes. Yamada and Chacaltana (2007) document six successful cases of firms expanding and generating employment. Access to exports markets was an important factor for firm expansion in the cases studied. The Municipal Scorecard report for 2007 asked firms that had obtained their business operating licenses and construction permits the main reasons why they decided to go formal. These firms identified not paying fines and law enforcement as the main reasons, while access to the judicial system and better credit were ranked as the least important reasons. While informative, these studies do not always provide systematic treatment of the different dimensions of informality nor do they have a broad coverage in terms of the number of businesses polled.

1.10 The report also studies the impact of informality on businesses’ profitability and access to credit. The first contribution of the report is to study the factors affecting informality controlling for a large number of business characteristics. A second contribution of the report is to analyze the impact of those factors. This requires econometric analyses that can establish the ‘causal’ links between the determinants of informality and variables of interest such as profitability or access to finance. While these analytical techniques have shortcomings, the estimates provide a contribution to the discussion of informality in Peru as a careful econometric analysis of the impacts of informality that was not available previously.

1.11 A key building block for the analysis in this report is a dedicated survey of 802 micro (up to 10 workers) and small (11 to 50 workers) businesses, both formal and informal. The National Household Survey (Encuesta Nacional de Hogares, ENAHO) provides a good basis for determining the extent of informality in Peru. It allows us to provide a clear answer to the extent of informality according to the legalistic definition, since it contains information on whether the respondents to the survey are covered by a pension or not. There is also information that can be used to construct a measure of informality according to the productive definition (as was done in phase I of this programmatic study). However, the objective of this study is to move one step further and explore the impact and determinants of informality. To answer these questions we need a firm-level data set of both formal and informal businesses that will allow us to control for a large number of business characteristics such as size, age, education of the owner, etc., that may be thought to affect the choices of firms on their trajectory towards formality. To this end the World Bank commissioned a dedicated business survey, as detailed in Box 2. While the survey conducted provides us with a cross-section of data by including questions such as ‘how long did the business operate before obtaining a license?’ it allowed us also to obtain information about the trajectories of businesses towards formality.

Box 2: A dedicated survey to study informality in Peru

To better understand the factors behind informality in Peru the World Bank commissioned a dedicated survey of businesses, both formal and informal. A total of 802 businesses were interviewed face-to-face in five cities: Arequipa, Cusco, Huancayo, metropolitan Lima, and Trujillo. These five cities were selected to reflect a cross-section of urban centers, accounting for more than 10 million inhabitants in total or around 36 percent of Peru’s estimated population. We restricted the survey to cities since urban informality has been the focus of the debate in Peru, largely on account that it is perceived to be in cities where the potential for reducing informality is greatest. In addition, informality in urban and rural areas may not share common characteristics.

Conducting a survey of both formal and informal businesses poses the challenge that there is no readily available census data to use as a frame from which to draw a random sample of businesses. To ensure as much as possible a random sample of respondents, the sampling was designed as a three step process. First, on the basis of the population census, a certain geographical area within a city was selected at random. Second, an enumerator was sent to that particular geographical area and was asked to list all businesses that could be found. While this necessarily introduces some selection bias, it is a pragmatic approach for addressing the complex issue of how to construct a frame from which a random sample can be drawn with limited resources. It is also an approach that has been successfully used in other cases (De Mel et al., 2007). Third, a random sample of businesses to interview was drawn from that list.

For businesses in metropolitan Lima (except those in transport) the first and second steps of the methodology were unnecessary since the survey firm already had a proprietary census carried out in 2007 of more than 100,000 firms covering the sectors of activity of interest. A pure random sample of informal and formal businesses would have resulted in a very large number of single-person businesses and very few businesses of 6 to 10 employees and of 11 to 50 employees. Therefore stratification quotas by city, industry, and firm size were applied to ensure that the sample covered sufficient observations to enable a statistical analysis of the results by different firm sizes and other categories (see Chapter 2 for descriptive statistics).

Only businesses operating in seven sectors of the economy were surveyed. The selected sectors were chosen to represent a broad cross-section of manufacturing and services activities: (i) shoe and leather manufacturing; (ii) textile and apparel manufacturing; (iii) wood products and furniture manufacturing; (iv) metal products manufacturing; (v) retail sales of foodstuffs; (vi) transport by land; and (vii) restaurants and hotels. In 2006 the combined seven groups of activity accounted for around 30 percent of Peru’s economically active population, and a somewhat higher figure of employment in micro and small firms. Transport by land accounted for 4.6 percent of GDP in 2006, restaurants and hotels for 3.7 percent, textile and leather manufactures for 2.2 percent, metal products manufacturing for 1.2 percent, and wood products and furniture manufacturing for 0.5 percent of GDP. However, it is not possible to exactly match the weight of the retail sales of foodstuffs in GDP (retail activities as a whole account for around 14 percent of GDP).

1.12 Focus groups, in-depth interviews, and case studies complemented the quantitative data gathered from the quantitative survey. The dedicated survey of businesses was complemented with qualitative information gathered from seven focus groups and 15 in-depth interviews with micro and small entrepreneurs. Participants in focus groups were micro and small entrepreneurs with at least two years in business. This allowed us to probe focus group participants about their trajectory towards formality. Participants in focus groups were grouped according to the size of their businesses. In particular, two focus groups were dedicated to entrepreneurs with up to 4 workers, two more for entrepreneurs with 5 to 10 workers, and three groups with owners of businesses with 11 to 50 workers. Participants in the focus groups undertook their business in one of the following areas of activity: manufacturing (textiles and apparel, wood and furniture, leather and shoes, metal products), retailing of foodstuffs, transport, hotels and restaurant, and construction. The in-depth interviews were targeted at business owners who also took an active role in an association of micro and small businesses (gremios), which tend to be better informed. This ensured that the data gathering effort polled those better informed micro and small business owners while avoiding that their presence in a focus group would affect the group dynamic and that they would come to dominate the focus group discussion. In-depth interviews were held with leaders representing associations of micro and small businesses in a range of activities: manufacturing of wood products and furniture (four interviews); manufacturing of metal products (three); textile and apparel manufacturing (three); shoe and leather manufacturing (one); retail of foodstuffs (one); transport (one); and construction (one). Different research guides were prepared for the focus groups and for the in-depth interviews. Both the focus groups and in-depth interviews took place in January 2008 in metropolitan Lima.

Informality in the sectors selected for the survey

1.13 The degree of informality observed in the sectors selected for the survey is close to the one seen for the economy as a whole (see Table 1.1). In addition to allowing us to compare measures of the legalistic and productive definition of informality, the ENAHO captures other characteristics of a business, where a respondent works, that can be thought of as reflecting how formal or informal the business is. In particular, the ENAHO contains questions on whether the worker has healthcare coverage; has a contract or not; whether the employer is a business that is registered with its own legal personality; and whether the business where the respondent works keeps any accounting books. As noted in the first phase of the study, informality in Peru is high regardless of the definition or aspect of it that one chooses to examine. As shown in Table 1.1, the same is also the case for the sectors selected to be included in our dedicated survey. However, the ENAHO is not a good source of information for understanding the trajectories of businesses towards formality since it does not provide us with information as to the reasons why businesses choose to remain informal or to formalize.

Table 1.1: Measures of informality based on the household survey in the sectors selected for the survey and in the economy

Percent of economically active population …

... informal according to the productive definition*

...without a pension (legalistic definition)

...without health coverage

...working without a contract

…working in firms without legal personality

…working in firms that keep no accounting books

Aggregate of selected sectors for the survey

85.7

85.6

79.9

85.9

88.1

82.3

All economic activities

75.9

80.8

71.7

73.4

81.5

76.9

Notes: Data for 2006. * See Appendix A for details on how this measure was constructed.

Source: World Bank staff calculations based on ENAHO.

1.14 Informality affects all sectors of the economy selected for the survey but is particularly high among retail firms. Informality is a phenomenon that affects all sectors of the economy. The widespread prevalence of informality across sectors is reflected in the sectors selected for the survey. Among the seven sectors selected for the survey, the share of workers with a pension ranges from 71 percent in the case of metal and machinery manufacturing to 89 percent in the case of retailers of foodstuffs and hotels and restaurants. Other measures of informality display a similar pattern, with retail of foodstuffs having the highest share of workers without a contract (92 percent) and the highest share of employees working in firms that are not registered with their own legal personality (93 percent). Among the manufacturing sectors included in the survey the share of workers without a pension is highest in footwear and leather manufacturing and in furniture manufacturing (86 percent in both cases).

1.15 Informality is particularly high among micro firms (with 10 or less workers). In both the sectors selected for the survey and in the economy as a whole, informality is a phenomenon that is highly correlated with firm size. As shown in Figure 1.2 the share of workers without a pension is around 90 percent for firms with up to 10 employees. The share of workers without a pension declines among those working in firms with 11 to 50 employees, although it is still relatively high at more than 60 percent. These data make it clear that controlling for firm size, and any other observable characteristics of firms, is essential to draw conclusions about the determinants of informality. The analysis underpinning Figure 1.2, in addition to other tables and figures was repeated using the different indicators of informality from the household survey, as reported in Table 1.1. The results obtained using these additional indicators are reported in Figure A.2 to Figure A.10 in Annex A.

Figure 1.2: Informality by firm size, for selected sectors and for the economy as a whole

As measured by the ratio of workers without a pension in firms of different sizes (2006)

Sectors selected for the survey

All economic activities

.5

.6

.7

.8

.9

1

Informality prevalence

1 to 56 to 1011 to 50

Number of employees

.5

.6

.7

.8

.9

1

Informality prevalence

1 to 56 to 1011 to 50

Number of employees

Source: World Bank staff calculations based on ENAHO.

1.16 The five cities included in the survey are located in regions with a diverse incidence of informality – within the high rates seen across the country. By including businesses from Trujillo (La Libertad), Huancayo (Junín), and Cusco, the survey draws from cities in regions where the share of workers without a pension is relatively high (above 85 percent) compared to Lima and Arequipa (70 percent), as shown in Figure 1.3.

Figure 1.3: Map of informality prevalence by region

Percent of workers without a pension (2006)

S(r

n

)

I(r

g

)

r

g

r

n

I

e

=S

e

Note: Informality rates are shown at the departmental level since this is the most disaggregated geographical unit for which the annual ENAHO survey provides a representative sample of the population.

Source: World Bank staff calculations based on ENAHO.

1.17 Even though urban areas are typically richer, the choice of cities for the survey reflects a range of average incomes and incidence of informality. Informality is highly correlated with income levels, as Figure 1.4 shows. This is an important factor when designing any research into informality and when interpreting the results. In our case, the inclusion of cities such as Cusco and Trujillo ensured that the dedicated survey did not only cover the richest areas of the country. Finally, the positive correlation between average incomes and formality makes the importance of exploring possible directions of causality very clear: is it that formality contributes to higher incomes or that those with higher incomes self-select themselves into more formal arrangements? These questions are explored in Chapter 3, which includes an analysis of the impact of informality on the profitability of businesses.

Figure 1.4: Informality prevalence by region and income per capita

Informality as measured by the ratio of workers without a pension (2006)

Amazonas

Ancash

Apurímac

Arequipa

Ayacucho

Cajamarca

Callao

Cusco

Huanca-

velica

Huánuco

Ica

Junín

La Libertad

Lambayeque

Lima

Loreto

Madre de Dios

Moquegua

Pasco

Piura

Puno

San Martín

Tacna

Tumbes

Ucayali

.6

.7

.8

.9

1

Informality prevalence

400050006000700080009000100001100012000

Average annual income per capita, Nuevossoles

Source: World Bank staff calculations based on ENAHO and INEI.

1.18 The sectors selected for the survey are also representative of the economy as a whole with regard to trends in informality. Informality, as measured by the share of workers with a pension, has declined in the sectors selected for the survey in line with the decline observed for the economy as a whole. As measured by the proportion of workers without a pension, informality declined from around 87 percent in 2003 to around 80 percent in 2006. Informality also declined in the sectors selected for the survey, as shown in the left panel of Figure 1.5. These declines in the level of informality have taken place in a context of accelerating economic growth since 2004, as shown in the right panel of Figure 1.5. This evidence suggests that while informality may be a persistent phenomenon, strong economic growth has contributed to its reduction in recent years. However, using alternative indicators of informality based on the ENAHO, there has been no significant decline in recent years in the share of workers without a contract or working in businesses without a separate legal personality or without accounting books (Figure A.8 to Figure A.10 in Annex A). In addition, one has to bear in mind that the decline in informality, as measured by the lack of access to a pension, has required ever increasing rates of economic growth, as shown in the right panel of Figure 1.5.

Figure 1.5: Informality rate and economic growth, 2003 to 2006

Informality as measured by the percent of workers without a pension

Informality rate for sectors selected for the survey and for all economic activities

Informality rate (all economic activities)and economic growth

70

75

80

85

90

95

2003200420052006

Informality rate

All economy

Selected sectors

70

75

80

85

90

95

3.5%4.5%5.5%6.5%7.5%8.5%

Real GDP growth

Informality rate

2005

2003

2004

2006

Source: World Bank staff calculations based on ENAHO and INEI.

1.19 The remainder of the report reviews, in turn, the determinants of informality (Chapter 2) and its impact (Chapter 3). As part of the analysis of the determinants of informality the study identifies the trajectories of micro and small businesses towards formality. In addition, a number of boxes in the report pay particular attention to: (i) taxation of micro and small enterprises; (ii) sector-specific labor regimes; and (iii) unfair dismissal costs. These topics were selected in close cooperation with the authorities of the Government of Peru to address specific queries that the authorities had. In this regard the report contributes to the knowledge base for policy-makers by: (i) quantifying the tax burden on new capital investment by micro and small businesses under different tax regimes: (ii) providing a detailed compilation of labor regulations affecting different sectors; and (iii) producing a new data set that allows for a comparison between the payments to which a dismissed worker is entitled de jure and the actual payments that the dismissed worker receives after a conciliation process.

2. Determinants of informality

Scope: To explore why businesses choose to keep certain aspects of their operations informal we ask businesses themselves, through the dedicated survey and focus groups. We ask about businesses’ perceptions but also about their actual level of formalization along a range of dimensions and about a large number of characteristics of their businesses. This allows us to explore the determinants of informality econometrically.

Structure: The chapter is structured in four sections.

First, we provide information about the characteristics of the sample of businesses from which we are drawing information.

Second, we report what our respondents tell us, through the survey and focus groups, about the factors that drive their choices regarding formality and informality along a range of issues. This section is structured along four broad dimensions of informality: (i) business licensing; (ii) paying taxes; (iii) labor relations and access to a pension; and (iv) business incorporation.

Third, the chapter exploits the information from the survey to establish econometrically what factors affect the probability that a business is formal (as captured through some characteristics associated with formality). In addition, the chapter includes a number of boxes reviewing specific issues selected with the authorities as areas of particular interest: (a) taxation of micro and small enterprises; (b) sector-specific labor regimes; and (c) unfair dismissal costs.

Fourth, the chapter sums up the information from the different data sources, quantitative and qualitative, to describe the common paths towards formality among micro and small businesses.

A. Who is our source of information?

2.1 Businesses surveyed cover a broad spectrum of micro and small enterprises... Details of the actual businesses surveyed in terms of their size, location, and sector of activity is provided in Table 2.1. The qualitative data-gathering effort also took account of the heterogeneity of micro and small businesses. Therefore different focus groups were arranged for businesses of different sizes. In total, four focus groups were conducted with businesses of 10 or less workers and three focus groups were conducted with businesses of 11 to 50 workers. An additional source of information gathered was through in-depth interviews with micro and small business owners who are also representatives in associations (gremios) of micro and small businesses.

Table 2.1: Number of businesses surveyed

By size

No. of businesses

By city

No. of businesses

By sector

No. of businesses

1 – 3 workers

226

Arequipa

111

Shoe and leather

117

4 – 5 workers

195

Cusco

108

Textile and apparel

119

6 – 10 workers

201

Huancayo

93

Wood products

126

11 – 20 workers

149

Lima (met.)

368

Metal products

118

21 – 50 workers

31

Trujillo

122

Retail foodstuffs

105

Transport

95

Restaurants

122

Total

802

Total

802

Total

802

Source: World Bank survey of micro and small businesses.

2.2 … and a wide range of situations regarding how formal or informal they are. The ‘dimensions of informality’ that are explored in this chapter can be grouped into four broad categories: (i) business licensing; (ii) paying taxes; (iii) labor relations; and, (iv) incorporation of businesses as separate legal entities. Some of these dimensions of informality, like paying taxes and business licensing, are directly linked with the definition of informality as not being compliant with the laws and regulations. Others, like labor relations, have a direct link with the legalistic definition of informality discussed above (as it covers the extent to which workers have access to a pension). Finally, while a businessperson can operate formally as a natural person, the registration of the business as a separate legal entity emerged from the focus groups as a step that has important implications for a business. Table 2.2 shows the characteristics of the businesses surveyed along those four dimensions of informality, including a breakdown by size of business.

Table 2.2: Selected informality characteristics of surveyed businesses

Percent of businesses surveyed

All businesses

1 – 5 workers

6 – 10 workers

11 – 50 workers

Business licensing

Firm has municipal license

67

59

67

83

Firm has permanent municipal license

51

44

50

67

Taxes

Firm pays taxes*

69

56

77

89

Percent of sales reported for tax purposes**

53

51

58

53

Firm has RUC number

78

65

90

96

Firm files under RUS

28

33

31

14

Firm files under Special Regime (RER)

11

7

19

11

Firm files under General Regime

38

24

38

70

Firm never gives facturas or boletas

19

29

11

6

Labor relations

Firm has no workers with a labor contract

83

92

83

63

Firm has no workers with health insurance

71

83

71

45

Firm has no workers with pension coverage

83

93

84

59

Business incorporation

Firm has limited liability (SA, SRL, SAC)

17

6

16

44

Sample size

802

421

201

180

Notes: * Businesses were asked to detail their outlays for a month and to include how much they pay in taxes in that month. The figure reported in the table represents the share of businesses which reported a positive amount being paid in taxes; ** The question asked was: “Let us suppose that the true sales of a business are 1,000 soles a month. How much do you think that a business owner like yourself would report for tax purposes?”

Source: World Bank survey of micro and small businesses.

2.3 Bigger businesses are more formal across all dimensions of formality but are still largely informal regarding labor relations and often operate as natural persons. There are differences in the degree of informality along the different dimensions of informality analyzed and for businesses of different sizes. Bigger businesses, especially those with 11 to 50 workers, are more formal than smaller businesses. However, there is low formalization with regard to labor issues even among businesses with 11 to 50 workers: 59 percent of the businesses of that size surveyed have no workers with pension coverage and 63 percent have no workers with a written contract. Similarly, less than half of the businesses with 11 to 50 workers are incorporated as a separate legal entity with limited liability. Among businesses with 11 to 50 workers, formality along the other dimensions is much greater: 83 percent have a municipal license and 89 percent pay taxes. However, the assessment of how much income goes unreported to the tax authorities is similar for businesses of different sizes. (Additional breakdowns by city and sector of activity can be found in Annex B.)

2.4 Smaller businesses are relatively formal with regard to business licensing and paying taxes. While micro businesses of up to 10 workers are largely informal with regard to labor relations, they are relatively formal with regard to getting a municipal license and paying taxes. Even among businesses with 1 to 5 workers, 59 percent have a municipal license; 56 percent pay taxes; and 65 percent have a tax (RUC) number. The share of businesses with a RUC number increases to 90 percent among businesses with 6 to 10 workers. Smaller businesses are relatively more sophisticated regarding tax issues than may have been expected: 24 percent of businesses with 1 to 5 workers report filing taxes under the general regime. In fact, some large businesses use the simplified tax regime (designed for small businesses) and some small ones use the general tax regime (designed for larger businesses), an issue which will be explored further below.

2.5 The survey data confirms that there are different stages along the continuum from informality to formality. The survey provides us with a large number of formality characteristics for our sample of firms. To study which combinations of formality are most common we use principal components analysis. This allows us to identify which characteristics of informality are interrelated and can be grouped together. The results from this exercise are provided in Figure 2.1, showing that formality along the dimensions of business licensing and paying taxes are most common.

Figure 2.1: Share of surveyed businesses at different degrees of formality

Percent of firms by groups of formality characteristic

0

10

20

30

40

50

60

70

80

90

100

1 to 5 workers

6 to 10 workers

11 to 50 workers

Other combinations of formality

RUC, municipal license, all workers with

labor contract, and limited liability

RUC, municipal license, and all workers

with labor contract

RUC, municipal license, and limited liability

Municipal licenseand RUC

RUC only

Municipal license only

Nothing

Note: The underlying data is reported in the appendix in Table A.8.

Source: World Bank survey of micro and small businesses.

B. What do micro and small business owners tell us?

2.6 The pattern of selective formalization as businesses grow reflects the perception of costs and benefits associated with each dimension of formality. The focus group technique and the in-depth interviews with micro and business persons provide us with some insight into the decision-making process regarding formalization. Table 2.3 summarizes the key considerations when making those decisions as reported by micro and small entrepreneurs in the focus groups and interviews.

Table 2.3: Benefits and costs of formalizing perceived by micro and small business owners

Issue

Benefits

Costs

Key rationale for decisions regarding formalization

Dominant force driving formali-zation

Munici-pal business license

Informal (not having a license)

· Avoid paying the license fee

· Avoid heavy bureaucracy

· Possibility of fines and payments to inspectors

Municipal license is perceived to convey no benefits and as a heavy bureaucratic burden, often unreasonably enforced.

As firms grow and are more easily detected, they obtain the license to avoid repeated fines. Firms operating behind closed doors further delay obtaining the license.

Enforcement

Formal (having a license)

· Avoiding fines

· Annual fees

· High cost of dealing with the bureaucracy

· Fines still possible due to unreasonable inspections

Taxes

Informal (not paying, no RUC, no use of receipts)

· Avoid paying taxes