Formalization

Formalization, in economics and development policy, is the process of bringing workers, businesses and assets that operate outside formal arrangements into the formal economy. A formal firm is registered, keeps accounts and pays taxes; a formal worker has a contract and social insurance; a formal asset, such as land, has a recognised title. The term also has other meanings, such as writing an agreement down or expressing ideas in formal logic, but this entry covers the economic sense.

Formalization is the policy answer to the informal economy, which the International Labour Organization (ILO) estimated in 2018 employed about two billion people, more than 61% of the world's workforce. It is related to, but broader than, tackling the shadow economy, because most informal workers are not hiding anything; they simply have never been brought into the system.

Think of a home baker who sells cakes to neighbours for years. She has no business registration, no bank account for the business and no insurance. If an oven fire destroys her kitchen, she has no claim; if she wants a loan for a bigger oven, the bank has no records to look at. Becoming formal means signing up as a business, opening an account, keeping simple books and paying a modest tax.

In return she gains things she could not have before: a pension contribution record, the right to sign contracts with a supermarket, access to credit and legal protection if a customer refuses to pay. Formalization is the work of making that trade attractive enough, and simple enough, that people choose to make it.

• Business registration. Firms register with the state, obtain a tax identification number such as a TIN, and meet licensing rules.
• Employment. Jobs come with written contracts, minimum labour standards and contributions to social security.
• Tax. Income and sales are declared, bringing activity into the base for taxes.
• Property. Land and housing receive legal titles that can be sold, inherited or pledged as collateral.
• Finance. People and firms move from cash and informal banking into accounts, payments and credit, which overlaps with financial inclusion.

The main international standard is the ILO's Transition from the Informal to the Formal Economy Recommendation, 2015 (No. 204), adopted on 12 June 2015 at the 104th International Labour Conference in Geneva. It is the first international labour standard focused specifically on the informal economy. As a recommendation rather than a convention it is not binding, but it guides governments, employers and trade unions.

Recommendation 204 has three stated aims: to help workers and economic units move from the informal to the formal economy while respecting their rights and livelihoods, to promote the creation of formal enterprises and decent jobs, and to prevent formal jobs from becoming informal. It defines the informal economy as activities not covered, or insufficiently covered, by formal arrangements in law or in practice, and asks countries to collect data to track progress. Formalization also appears in the United Nations Sustainable Development Goals: target 8.3 calls for policies that encourage the formalization and growth of micro, small and medium-sized enterprises.

Countries have tried several approaches, usually in combination:

• Simplification. One-stop registration, online filing and lighter rules for very small firms lower the cost of becoming formal. Brazil's individual micro-entrepreneur (MEI) regime, created in 2008, lets the self-employed register cheaply and pay a small flat monthly fee covering tax and social security.
• Incentives. Access to public procurement, credit schemes, health insurance or pensions gives informal operators a reason to sign up.
• Property titling. Programmes inspired by the Peruvian economist Hernando de Soto, author of The Other Path and The Mystery of Capital, issue land titles so that homes can serve as collateral.
• Digital payments. Mobile money, electronic invoicing and government payments made into accounts create records that make declared activity easier and hidden activity harder, and reduce reliance on cash.
• Enforcement. Labour and tax inspections, used alongside incentives, raise the cost of staying informal.

Research on formalization finds mixed results. Cutting registration costs alone often produces only modest take-up, because many small firms see few benefits from formal status and expect higher tax bills. Studies of land titling have found gains in tenure security and housing investment in some settings, but weaker effects on access to credit than early advocates predicted. Formalization also tends to rise with economic growth and productivity, which makes cause and effect hard to separate.

Critics warn that pushing formality too hard can destroy livelihoods, especially for the poorest workers, and that formal status means little if enforcement of labour rights is weak. New forms of work raise fresh questions: platform workers in the gig economy may be registered and paid digitally yet classified as an independent contractor without social protection, which some analysts describe as informality within a formal setting.

• ILO Recommendation No. 204 (NORMLEX)
• International Labour Organization