Why the informal sector may hinder local private investment

Kenya’s large informal economy, which is largely made up of micro, small and medium enterprises (MSMEs), is considered a source of unfair competition for mainstream businesses.

The illegal practices that some of these businesses engage in during their operations are seen as detrimental to mainstream companies that must strictly adhere to every rule in the rulebook.

Therefore, this is also private When making decisions, the company considers If the business environment is favorable they will inject more capital.

A recent paper published by the Kenya Institute for Public Policy Research and Analysis (Kippra) points out that the business environment lacks enforced regulations that should provide a level playing field for all businesses.

“Regulators could further identify existing regulations that unnecessarily restrict competition or reform overly restrictive labor, tax and product regulations that encourage informality,” reads the paper titled “The Impact of the Business Environment on Capital Investment by Private Enterprises in Kenya.”

Kenya has about 18 million MSMEs, which are either briefcase businesses or businesses that have a designated location but still operate on their terms, according to the country’s Ministry of Micro, Small and Medium Enterprise Development.

However, the Kenya National Bureau of Statistics (KNBS) recorded a figure of only 7.5 million.

“Given the importance of Kenya’s informal sector in terms of job creation and output, one of the things government agencies can do is to strengthen regulation and compliance in the informal sector to ensure a level playing field for all investments,” Kipura said in the paper.

The Micro and Small Enterprises Authority (MSEA) defines a micro enterprise as an enterprise with an annual turnover of Sh1 million or less and employing fewer than 10 people.

Small businesses have an annual turnover of between Sh1 million and Sh5 million and employ up to 50 people. It is reported that the country’s MSMEs contribute up to 33.8% to the gross domestic product (GDP) and employ nearly 15 million people.

The assertions made by Kippra in his paper are based on a study that aimed to assess the impact of the business climate on capital investment by private firms in the country.

In addition to competition in the informal sector, other business environment variables mentioned in the study include tax payment, access to finance, corrupt practices, and the type and size of businesses.

The study also examines the policy and regulatory framework related to the country’s business environment.

“The review shows that while policies and regulatory frameworks to support private investment are in place, there is a need to coordinate policies with competing objectives and further implement some key recommendations, such as the establishment of an investment committee. These would provide the necessary impetus and stimulate more private investment,” the document states.

Kippra’s research shows that firms that consider informal sector competition as a barrier have 0.56 units lower levels of capital asset investment than firms that do not.

“The findings suggest that competition from the informal sector affects firms’ investment levels. This finding is consistent with Pisani (2015) who noted that formal firms are negatively affected by competitive pressure from informal firms, especially due to non-compliance,” Kippra said.

This article cites the 2018 World Bank survey shows Practices in the informal economy accounted for 17.9 percent, ranking second as one of the challenges related to the business environment, after political instability (19.6 percent). Corruption accounted for 10 percent.

But this fierce competition is not universal. A World Bank survey in Latin America shows that companies in industries with low fixed costs and low entry barriers are more likely to face competition from the informal sector.

The report cites another study on the Nicaraguan economy that showed that formal businesses are negatively affected by competition from informal businesses, whose noncompliant practices create barriers to competition.

“However, the study further noted that formal firms that have been operating for a longer period of time are less threatened by informal businesses than newer firms,” the report explains.

“In addition, the research also shows that formal businesses behaving in ways similar to informal businesses (through non-compliance and other informal business strategies) also pose a threat to formal businesses that fully comply with regulations.”

Kippra said the government’s ability to enforce regulations is crucial in this fight because it determines whether companies comply with regulatory requirements.

“In an environment where the government’s enforcement capacity is strong, informal businesses face less risk of being investigated and punished, and pose less of a threat to formal businesses,” the report said.

The report adds that while competition is a good thing for markets, it is not necessarily true as competition between formal and informal businesses can be ineffective as the latter enjoy cost advantages due to not complying with most government regulations.

“This allows informal firms to flourish at the expense of formal firms, and to capture market share from formal firms even when adopting inefficient production technologies,” the paper reads.

However, despite this competition, Kipla noted that informal businesses also contribute positively to formal businesses, as documented by the KNBS.

“For example, (formal firms) provide them with inputs and serve as a market for some of their products. In addition, informal firms can increase the variety of products sold in the market,” it added.