5 ways to make formalization worth it for Africa’s entrepreneurs

Africa doesn’t need another push to bring informal businesses into registration. Rather, it needs to make formality a more attractive economic option. In a previous piece on rethinking informality in Africa, I suggested that people too often see the informal economy as a deviation from the formal sector norm. They imagine that in one form or another, millions of entrepreneurs and workers would, if only they could, come under the umbrella of regulation. That view of informality is mistaken, both economically and in terms of policy. To many Africans, informality is where they produce, trade, work, and build their businesses every day. It is their main economic space.

To appreciate this, we need to go a step further. Informality persists because, in many cases, limited formal jobs, weak financial markets, unreliable infrastructure, and weak state capacity make informality the best option. Evidence across West African countries identifies not only survivalist enterprises and top performers but also “constrained gazelles,” entrepreneurs with productive potential whose businesses remain constrained by their environment. My own research on informal sector heterogeneity similarly shows that workers tend to choose different kinds of entrepreneurship and subsistence work depending on their opportunities, capital, and skills.  They aren’t necessarily choosing informality over formality. Rather, they often choose informality as a response to constraints.

That fact should shape our policy approach. Instead of asking, “How do we encourage registration of informal firms?” we should ask, “Under what circumstances would an entrepreneur willingly choose to formalize?” This reframing points to a different approach to formalization, one that focuses on value for the entrepreneur rather than nominal status.

Why decades of ‘register first’ policies have disappointed

Over the years, governments and development agencies have tried to simplify registration, cut licensing costs, create one-stop shops, and improve enforcement. In doing so, they assume that simply registering a firm will improve its performance and increase tax revenues. But experimental evidence shows this isn’t necessarily true. In Benin, Benhassine, McKenzie, Pouliquen, and Santini found that simplified legal status and intensive help led more firms to register. But these new formal firms saw no increase in sales, profits, customers, or financing. In some cases, formalization costs outweighed tax revenue for years. In Malawi, Campos, McKenzie, and Goldstein found that small firms showed considerable interest in free business registration but little interest in tax registration. When they offered support for registration combined with bank-led information sessions inform about potential benefits, however, profits increased by about 15% and sales by about 20%.

The lesson is not that incentives don’t work, but that formalization becomes valuable only when formal status unlocks something economically meaningful for firms. Too often, governments ask firms to bear the costs of reporting, taxation, registration, and inspection before they receive any benefits, even though evidence shows that entrepreneurs formalize when expected benefits outweigh monetary and administrative costs. Unless policy changes this equation, it would be rational for firms to remain informal.

Building a value proposition for formality

The answer to reducing informality isn’t just to cut registration costs. A broad review of the evidence points out that informality in many countries is rooted in differences in firm characteristics, enforcement, and the costs and benefits of formal operation. Simplifying administrative processes can help, but it won’t change the economics of the firm. What Africa needs is a new deal: In exchange for greater compliance and visibility, enterprises should have more security, opportunity, and access. At minimum, such a deal should include the following five elements.

1. Making formalization a gateway to capital

Probably the most important, and certainly the most direct, benefit of formal entry for microenterprises would be financial. Credit constraints are among the biggest obstacles to firm growth and entrepreneurship. My research on constrained entrepreneurship shows that capital constraints shape many entrepreneurs’ decisions and the size of their firms, while related work on delayed entrepreneurship shows that these constraints can severely delay entry into productive entrepreneurship. The financial benefit of registration therefore needs to be tangible, such as a window for credit guarantees for micro and small enterprises under a simplified registration process, access to working capital loans, invoice financing, equipment leasing, or investment capital. Governments need not provide finance themselves, but they could take on some risk for the banks, microfinance institutions, fintechs, and others who would otherwise be unable to lend to such firms given their limited financial history and collateral.

Digital payments could provide a foundation for this. In work with Cédric Okou, we argue that digital technologies improve market access for informal enterprises and increase their chances of becoming more productive and legible to lenders through built-up financial histories. Visibility turns into an asset for entrepreneurs rather than merely a tool for government surveillance.

2. Turning infrastructure and business services into a formalization dividend

Finance can’t improve productivity without reliable electricity, transport, digital access, storage, and suitable premises. World Bank research on boosting productivity in Africa shows that, because of infrastructure and business environment constraints, firms cannot invest, grow, and operate efficiently. Formal micro and small firms would benefit from consistent (or preferential) access to enterprise zones and serviced markets with, for example, broadband, electricity, water, storage, waste collection, sanitation, and workspace, under simplified tariffs. To add value, formal microenterprises could receive business development services, accounting tools, digital tools, sector-specific technical support, and certification.

This doesn’t necessarily mean ongoing subsidies. Governments could offer declining rates as a firm grows, infrastructure to lower costs, and digital billing to improve cost recovery. But behind all of this lies the idea of reciprocity. If all that a tailor gets from formalizing is a tax number, if a food processor still loses product because the refrigerator breaks, if a manufacturer still needs a diesel generator, they have little incentive to formalize. With the right infrastructure, a formal firm would be better positioned to produce.

3. Attaching social protection to the enterprise, not just the formal wage job

A key disadvantage of informality is that risks faced by households and their businesses overlap. A death in the family, sickness, hospitalization, disability, fire, theft, or maternity can cut into household income and undermine a business. In a piece with Omer Zang on microinsurance, we argue that conventional insurance products do not fit well with the economic reality and variable income of small businesses. An ILO report on informality and social protection in African countries shows that such workers often have very different incomes, employment relationships, and capacity to contribute than those assumed in traditional payroll-based social insurance.

In a simpler regime for these businesses, we could automatically include health, accident, disability, maternity, business, and pension protection, with payment frequencies reflecting variable and unpredictable incomes in small-scale activity and paid via digital business accounts or mobile money. Policymakers could therefore make access to meaningful protection an incentive for entrepreneurs to formalize.

4. Making the law work for small firms

Formal status should give a firm an advantage over many informal firms in terms of legal protection. It should be reinforced with enforceable guarantees such as small-claims processes, easily accessible mediation, standard contracts, online complaints, regular (but predictable) inspections, no arbitrary closure or confiscation, and the ability to appeal decisions by the authorities. Yet if registration and digitalization make an entrepreneur more visible to tax authorities, municipal officials, and inspectors without these protections, formalization would put them at risk. As I discussed in “Rethinking informality in Africa,” in order to be attractive, the relationship between formalization and the state should shift from exposure to enforceable rights.

5. Putting markets and public procurement on the table

For many firms, one of the strongest incentives to formalize would be customers. Often, small African businesses operate in local markets with unpredictable demand, and registration alone won’t change that. Yet large corporations, development agencies, regional value chains, and governments all have considerable purchasing power. Public procurement could therefore be a powerful tool for formalizing small businesses. Governments could set aside some of their small contracts for micro and small enterprises, break up large contracts so small suppliers could bid on them, introduce regulations for timely payments, make it easier for small firms to bid, and build ladders in procurement that would allow a firm to move up from small to larger contracts over time. Brookings research on barriers to public procurement for women-owned businesses in Africa shows that structural and administrative barriers often keep small enterprises from tapping into this vast demand.

In addition to the government, formalization programs could help connect small firms with agro-processors, exporters, mining companies, supermarkets, hospitality businesses, and online  marketplaces. They could also help these businesses meet standards of quality, packaging, accounting and certification. Under the African Continental Free Trade Area, small firms with potential could enter regional markets. Without reliable customers, small businesses would struggle to stay profitable and look riskier to lenders.

The power is in the bundle

None of these tools should be considered on their own. A credit guarantee is less useful if electricity isn’t reliable. Without customers, electricity won’t help a business. A government contract may well be impossible without working capital. More sales could put the owner at risk if they have no health insurance. And all these advantages would diminish if, through greater visibility, the entrepreneur risked arbitrary harassment by authorities or unpredictable taxes. Policy should therefore focus not on the registration certificate but on a package of tools.

Imagine a basic “productive enterprise” status with low-cost, digital registration. If a small enterprise registered under this, it could gain a business account, a transaction history, access to a partially guaranteed loan, social protection, business infrastructure, accounting help, commercial dispute resolution, and some opportunities in public procurement. Tax could initially be simple, predictable, and based on turnover or income. As the business grew, thresholds and rates could rise, and the benefits, obligations, and conditions of moving up from this status could be set in advance. The key point is that these interventions complement one another and together, they create economically meaningful effects on what a firm can sell, produce, protect, earn, and finance.

Importantly, the bundle doesn’t need to be complete to begin working, nor does it need to be perfect. Few governments in Africa can simultaneously provide finance, infrastructure, market access, legal protection, and social protection to millions of small enterprises. But they could make incremental progress on several interlinked dimensions that would progressively increase the value of formality for entrepreneurs. Cabo Verde is one example of a country that has built a simplified regime for small and micro enterprises, including credit, credit guarantees, tax relief, and social security. Under this regime, registrations of such enterprises more than quadrupled between 2016 and 2020, with considerable impact. Another example of incremental reform is in Rwanda. Over the years, it has combined simplified, increasingly digital business registration with tax, credit, electricity, and contract reforms. As a result, the number of limited-liability companies set up each year has risen 23-fold.

These instructive examples and the contrasting experimental evidence discussed earlier reinforce the same point. Firms value registration more when their benefits are sufficiently valuable and complementary enough to change their production possibilities, not just their legal classification.

Why this can also be a better deal for the state

Governments may reasonably ask: Who pays for these interventions? But answering that question requires considering the current costs. Trying to register, monitor, and tax millions of low-productivity, very small enterprises is costly and currently yields little revenue. The Benin formalization experiment increased registration of such enterprises but failed a narrow fiscal cost-benefit test, because it did not change the economics of the enterprises in question. A productivity focus underlines the potential value of a tax base in these enterprises. With more capital, better access to markets, greater resilience to shocks, more employees, and higher profits, these enterprises will eventually generate more economic activity for governments to tax. Invoicing, payments, procurement, financial transactions, and the use of digital accounts could cut the cost of tax collection for these enterprises while helping them access finance.

Fiscal policy can and should be explicit, while trust is equally important. OECD evidence from African tax administrations emphasizes the importance of trust in facilitation between tax authorities and taxpayers. If taxpayers could see that, in exchange for paying taxes and compliance, they gain access to markets, protection, finance, and infrastructure, they might feel more inclined to engage in that fiscal deal. In that case, the result would be a virtuous cycle. Better services would spur productivity. More productive firms would be more likely to formalize. More formalization would raise the tax base. And with more revenue, the state could offer even better services.

From forced formalization to chosen formalization

Formal enterprises can take advantage of economies of scale, enter larger contracts, use complex financial tools, build long-term relationships with suppliers and labor, and support the revenues of capable states. But this doesn’t mean governments should force firms toward formality. A more promising prospect would be the reverse. Make markets more accessible, electricity more reliable, insurance more portable, contracts more enforceable, public procurement more available, and taxes more predictable, in a way that it becomes useful to engage with the state. Then entrepreneurs, as rational economic agents, will choose the option with the best expected return. For decades, Africa’s formalization agenda has been, “What will you give the state in return for formality?” A more successful agenda would instead start with, “What might you gain from formalizing?” When the answer becomes compelling enough, governments may find that they no longer need to force firms into formality. Firms will want to join it on their own.