Why informal sector could be choking local private investments

Kenya’s vast informal economy which is largely made up of micro, small and medium enterprises (MSMEs) has been cited as a source of unfair competition for mainstream firms.

The lawlessness that some of these businesses operate under has been termed disadvantageous to mainstream firms that have to abide by every rule in the rule book.

As such, it is one of the reasons private firms look into it when deciding if the business environment is conducive for them to inject more capital.

The recent paper by the Kenya Institute for Public Policy Research and Analysis (Kippra) notes the lack of enforcing regulations in the business environment which should provide a level playing field for all enterprises.

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“The regulatory agencies can further identify existing regulations that unnecessarily restrict competition or reform the overly restrictive labour, tax, and product regulations; this would encourage businesses to operate informally,” reads the paper titled Effects of Business Environment on Private Firm’s Capital Investments in Kenya.

Kenya hosts about 18 million MSMEs according to the State Department for MSME Development, which range from briefcase enterprises to those with specified locations but still operate on their terms.

However, the Kenya National Bureau of Statistics (KNBS) documents just 7.5 million.

“Given the importance of the informal sector in Kenya regarding job creation and generation of output, one of the things that government agencies could do is to enhance regulation and compliance in the informal sector and ensure a level-playing ground for all investments,” says Kippra in the paper.

The Micro and Small Enterprise Authority (MSEA) describes a micro business as that with an annual turnover of Sh1 million and below with less than 10 people employed.

A small enterprise has an annual turnover of between Sh1 million and Sh5 million with up to 50 employees. MSMEs in the country are also known to contribute up to 33.8 per cent to the Gross Domestic Product (GDP) employing close to 15 million people.

The assertions made in the paper by Kippra are based on a study that sought to assess the effects of the business environment on private firms’ capital investment in the country.

Apart from informal sector competition, the other business environment variables cited in the study are payment of taxes, access to finance, corrupt practices, and the type and size of the firm.

The study also reviewed policy and regulatory framework related to the business environment in the country.

“The review indicated that while the policy and regulatory framework to support private investments is in place, there is a need to harmonise policies with competing objectives and further operationalise some key proposals such as the establishment of the Investment Council. These will provide the necessary impetus and spur more private investments,” the paper states.

The study by Kippra determined that firms that considered informal sector competition as an obstacle reduced investment levels in capital assets by 0.56 units than firms that did not.

“Informal sector competition affects investment levels of firms as noted in the findings. This finding is consistent with Pisani (2015) who noted that formal businesses are negatively impacted by competitive pressure from informal businesses particularly due to non-compliance,” says Kippra.

The paper references a 2018 World Bank Survey that states practices from the informal economy at 17.9 per cent coming second after political instability (19.6 per cent) as some of the business environment-related challenges. Corruption had a score of 10 per cent.

However, the choking competition is not across the board, with reference from a World Bank survey in Latin America that businesses in industries with low fixed costs and low entry barriers are likely to face informal sector competition more.

It cites another study on Nicaragua’s economy which showed that formal businesses are negatively impacted by competition from informal businesses whose practices of non-compliance create competitive obstacles.

“However, the study further noted that formal firms that have been in business for a longer period experienced fewer threats from the informal businesses compared to the new ones,” it explains.

“Additionally, the study showed that formal businesses behaving like informal ones (through non-compliance and other informal business tactics) were also a threat to formal businesses that fully complied with regulations.”

Kippra states that a government’s ability to enforce regulations matters in this fight as this determines a business’s decision to either comply or not comply with the regulatory requirements.

“In an environment with a high government capacity to enforce regulations, informal firms would risk being caught and would pose less threat to formal businesses,” it says.

It adds that while competition is a good thing for the market, it may not be necessarily so, as the fight between formal and informal businesses may be unproductive due to cost advantages that the latter section of the economy enjoys due to non-compliance with most government regulations.

“This makes the informal businesses thrive at the cost of the formal ones and take a share of their market even when they use inefficient production techniques,” the paper reads.

But despite this competition, Kippra notes that informal businesses have also been shown to contribute positively to formal businesses as documented by KNBS.

“For instance, by (formal businesses) supplying inputs to them and being a market to some of their products. Further, informal firms can also lead to an increase in the variety of products sold in the market,” it adds.