The reasons behind vast informal economy and lacklustre growth of businesses

Kamal runs a profitable business in Kathmandu city manufacturing plastics for food packaging. Despite his business flair, Kamal does not want to scale up his small factory. He wants the factory to be like that. “I don’t want to expand because I earn more working in this way”, he says. So far operating beyond the ambit of the government, expansion will force his business to get registered and in turn pay “eye-watering” 25% of profits in tax. He says, “nobody likes the idea of paying tax.”

Nepal should benefit enormously from its fastest growing neighbouring economies in the world–China and India–with which it shares a long land border given its advantages. It is part of a free-trade area that lets its industries take advantage of South Asian supply chains. It has so far eluded painful inflation and unsustainable debt of South Asian economies like Sri Lanka. Over the last two decades Nepal has managed average economic growth of more than 4%, higher than some of its regional peers.

Yet Kamal’s story helps explain what factors are forcing informal businesses to stay in the grey economy. Look closer and, surprisingly, the same factors are behind the poor performance of formal businesses, too.

A cocktail of factors stands to explain why people prefer to slog away in the grey economy. “It’s like Khichdi, with many elements,” jokes a business owner. Bureaucracy, unfriendly business environment and high tax rates (even for small businesses) are not only discouraging informal businesses and workers from moving to the formal economy, but also putting the brakes on formal businesses’ fortunes from growing. 

Formal businesses have to deal with bureaucracy and high taxes. In return they get shoddy public services. This is why so many firms and workers are reluctant to move to the formal sector. Almost 70% of the labour force and 50% of businesses do not pay the taxes. Forget about informal businesses providing social-insurance to employees.

Worse, the informal sector disregards labour compliances and often treats employees poorly. The share of the shadow economy to GDP is well below that of the formal economy despite the large number who break a sweat in it. This is explained by its lower productivity than the formal sector productivity. 

Tackling the high share of the informal sector would mean enticing informal businesses with an effective tax system that is both lower and attractive, and excellent public service. 

Difficulty of paying taxes is another headache for formal businesses. In 2018 Nepal ranked 158th for ease of paying taxes in the World Bank’s Doing Business ranking out of 190 countries. What this means is that the cost of paying taxes is often higher than the tax rates written on paper. 

A labour act introduced in 2017 paved the way for employees to get medical insurance, labour gratuity and accident insurance from employers. Though a good measure, labour gratuity particularly added administrative burden on firms, because they now had to pay for it every month–manually.

The result: companies had to make 39 payments and spent 353 hours to meet their obligations (global average is 24 payments and 237 hours), “taking time and resources away from generating profits to employ workers and spread prosperity,” says Faris Hadad-Zervos, World Bank Country Manager for Nepal. 

One often overlooked consequence of high tax is the resulting tax incidence. Undergraduate students of economics know that companies always respond to high taxes by passing some of its burden onto customers and workers in terms of high prices and low paychecks, respectively, in order to maximise their bottom line. But exactly by how much remains an open question.

Life for labourers in the informal economy is not rosy. In Bhaktapur, Suvangi Basnet runs a fruit-and-vegetable stand. The hours are gruelling. She opens the stall for 12 hours a day. Suvangi says her earnings have not risen in recent years. Rising inflation is of concern, too.

Shiva Tamang, who sells freshly made dairy products in another part of Bhaktapur, says he would go out of business if he had to pay taxes he couldn’t afford. 

Neither work in the formal sector—though appealing. Working in formal jobs could mean workers receiving health insurance, pension and good salaries. But their benefits are scant. For instance, benefits of health insurance provided by employers are no more attractive than those that can be obtained for a small premium.

Despite 20 years of service in the formal sector to earn a pension in Nepal (compared with 20.3 years in the Asian countries outside the OECD) and pensions increasing by 10% every three years, public pensions have done little to nudge informal workers to become formal ones.

Local factors have put pressure on growth, too. Cartels and syndicates obstruct new competitors from entering the market for fear of losing customer base, depriving the market of healthy competition. More challenges abound. Nepal performs terribly in ease-of-doing-business: the World Bank ranked the country 94th out of 190 countries in 2020.

Factories struggle to get continuous supply of electricity. Paying taxes crimps a lion share of firms’ profits in the formal sector. Low-quality infrastructure obstructs businesses from expanding their services to corners of the country. 

Massive investment in infrastructure is needed to connect poorer districts to the cities in order to improve the business environment, says an official at the Ministry of Industry, Commerce and Supplies.

Nepal experienced some success in building a manufacturing sector in the 1980s and made good progress on exporting garments and woollen carpets. But its exports took a beating after America did away with the Multi Fabric Agreement in 2003 and India imposed quota restrictions on major Nepali manufacturing products in 2009. The share of manufacturing to GDP took a nosedive from 8.84% in 2000 to 4.44% in 2020.

Past policy reforms have sought to boost economic growth. Yet few administrations have been hell-bent o shrinking the share of informal businesses, despite potential gains in the form of higher productivity and tax revenue to government coffers. 

Even so, the economy can still prosper. Nepal has high tax rates, but the coverage is very low. The country should widen the tax base and make tax evasion hard by monitoring economic activities through digitisation and better enforcement.

When coverage becomes high, the shortfall that arises from giving tax breaks to firms – to stoke investment – will be padded with increased revenue. Reforms to improve firm registry and facilitate entry of new businesses would be welcome measures. Crushing the burden of taxation firms face matters, too.

Attracting foreign direct investments through creating a better investment climate, and giving FDIs the access to areas where Nepal lacks behind, such as manufacturing high-value-added products, could also benefit the economy over the long run.

The country’s wealth would grow if it became more business-friendly and invested in infrastructure and eased regulatory hassles. Until then, the kind of development that the country aims to achieve in the coming years will be put on hold.