The burden of compliance on SMEs

SMES and informal businesses in Zimbabwe today are facing numerous barriers to formalisation and growth. There are so many hurdles that are inhibiting the formalisation of small businesses that entrepreneurs end up giving up on efforts to formalise.

Mostly the challenges emanate from the huge costs and legal and institutional difficulties in formalising small businesses. I will try and unpack some of them in this article.

The collective basket of issues is now commonly known as the “cost of compliance” and plays a significant role in the decision matrix of any micro or small business that seeks to expand or formalise its operations.

A lot of research across the world, including Zimbabwe, has been done on the subject, and one thing that is clear from the research is that there exists a continuum between the formality and informality. Even with the most formal business, very few businesses follow all the rules governing formal enterprise behaviour, and on the extreme scale of informality, for their own reasons, some businesses will follow none of the rules set for formal businesses.

The debate on formalisation has therefore settled on the notion that formalisation can be viewed as a gradual process that does not involve moving from one fixed state to another. The degree of formalisation varies immensely from a business that may be registered but not pay any taxes nor declare their employees earnings for the purpose of social security insurance. On the other hand, a business may not be registered as a formal company with the Registrar of Companies or government, but nonetheless comply with many local authority regulations.

A 2004 fact-finding study by SIDA and other research conclude that entrepreneurs will make repeated economic calculations in the form of a cost/benefit analysis, which determines a minimum threshold of participation in formal arrangements for which the costs remain lower than the benefits, that is to say - businesses will embrace formality up to the point where the marginal costs of so doing are less than the benefits they will gain.

For those enterprises that are making a decision about their level of formality, there are certain barriers that are weighed in heavily on the cost/benefit analysis.

These barriers have been identified in a number of pieces of researches, such as the SIDA fact-finding study referred to earlier, the annual World Bank Doing Business reports which conduct compliance cost surveys of the informal sector.

These reports typically suggest that barriers to formalisation fall into several broad categories, which include: regulatory barriers; administrative barriers; fees and financial requirements; corruption in public administration; socio-cultural attitudes; lack of key business services; and criminality.

The first three are defined as the microeconomic and regulatory and administrative barriers to formalisation, ie regulatory barriers; administrative barriers; fees and financial requirements. These, including corruption, have a direct effect on entrepreneurs’ willingness to engage with government present the basis for the increasing costs of compliance particularly for the informal sector businesses as they try to formalise their operations.

There is a strong global body of evidence to suggest that the above factors, in particular corruption, have the most direct influence on the formalisation decision of small businesses.

The other factors no doubt play a part in the decision, but much less directly so, and some economists argue that they are perhaps more barriers to growth than specifically to formalisation.

Regulatory barriers, administrative barriers and fees are closely linked and it is sometimes difficult to distinguish between them. They are considered as generic barriers. The specific areas where these three forces converge to give possibly the most significant barriers to formalisation are taxation, business registration/licensing requirements and compliance with labour laws.

Because of the many administrative layers required for one to go through before their informal business may be turned into a more formal one, the bureaucratic processes not only act as a disincentive for entrepreneurs but create an incentive for the public officials to create rent seeking opportunities for themselves.

For example, if registering a company with the registrar of companies takes an inordinately lengthy amount of time, it creates an opportunity for officers from that office to ask for incentives from seekers of those services to “expedite” their documents.

Another example being commonly cited in Zimbabwe is in the liquor trade where multiple stage licensing requirements are resulting in entrepreneurs being forced into side contracts with enforcement agents for them to look the other way if their licenses are not in order. Liquor outlets are required to renew their licenses every six months but via several government and local municipal offices who reportedly sometimes take several weeks just to put a stamp on a license document.

In these situations where time costs are converted into financial costs, the revenue from such activities goes into the pockets of the officers and not the institutions they represent. So services will not improve because resources are being diverted and above all the officials themselves will have very little incentive to improve services either as they benefit from the bottlenecks in the system.

The fatigue generated by the first four barriers does contribute to negative socio cultural attitudes about formalisation of businesses. If it becomes generally accepted that running a formal business is difficult and fraught with many pitfalls, over time people will prefer the less formal set-ups.

Sometimes the dearth of key business services in an area will lead to business people shunning formalisation. If the authorities are not providing essential services and infrastructure for businesses to function properly, business people will respond by also not wanting to contribute a fair share of taxes to fund those services. They will naturally avoid the tax net.

Lastly, and sadly some businesses simply will not formalise because their underlying business operations may not be entirely above board in legal terms. The owners have no incentives to have a business setup that may potentially expose them to legal scrutiny.