Informal Competition and productivity in Sub-Saharan Africa

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The characteristics of Micro and Small enterprises in Egypt

M/SEs in Egypt are identified using the quantitative criterion which takes into account the number of employees, as well as the value of fixed assets and the turnover rate per enterprise. According to the Micro and Small Establishments law (2005), a Micro enterprise includes a maximum of 10 workers and EGP 50 000 of invested capital (about $8 500), and a small enterprise includes a maximum of 49 workers and one million EGP of invested capital (about $170 000).8 According to the CAPMAS Establishment Census of 1996 and the 1998 Egyptian Labour Market survey, the percentage of M/SEs in total establishments decreased from 99.7% to 90% between 1996 and 1998.9 However, its share increased again in 2010 and reached 99% of Egyptian enterprises, 85% of non-agricultural private sector employment, and almost 40% of total employment (Nasr, 2010). According to the Ministry of Foreign Trade (2003), the majority of M/SEs are located in Lower Egypt, among which Dakahliya governorate has the highest percentage of M/SEs. They are also more concentrated in urban zones, among which Cairo governorate has the highest percentage of M/SEs. Comparing formal to informal M/SEs (table 2.1, appendix 2), formal workers mostly work in medium and large enterprises (i.e. around 60% are in enterprises with at least 50 workers), while informal workers are more concentrated in micro firms (i.e. around 80% are in enterprises with a maximum of 10 workers). Female formal workers represent only 25.5%, while male workers represent 74.5%. Similarly, the share of male outweighs that of female in informal business (85% vs. 14%). According to the economic activity, table 2.2 (appendix 2) shows that formal and informal M/SEs are mostly concentrated in trade activities (55% for formal and 38.3% for informal firms), followed by manufacturing for formal firms (18%) and services for informal ones (30%). Comparing male and female informal workers, male are more concentrated in trade activities, while female are more concentrated in services.
According to these figures, M/SEs play a major role in supporting the national economy, especially in terms of creating job opportunities and combating poverty. That’s why this sector is receiving an increased attention from the government, the banking sector, the private sector and the donors. For example, in 2004 the government established a new law (no.141/2004) governing M/SEs and according to which they became under the responsibility of the Social Funds for Development (SFD) that ensure their social and economic development.10 The government has also undertaken many reforms to minimize entry-costs and to provide more flexible registration, taxation and licensing procedures (as the reform of the labour law in 2003 and the tax law in 2005 and 2014). Moreover, the Banking-Sector Reform Program (2008-2011), supervised by the central Bank of Egypt, devoted an integral part to the enhancement of M/SEs access to finance through the provision of simplified micro-loans by private banks. Similarly, in partnership with the SFD, the World Bank has launched in 2014 a US$300m project that provided a sustainable access to finance for M/SEs.
Despite these efforts, existing severe institutional imperfections are hindering the development of M/SEs and are pushing them to operate informally. Egypt has still a long way to go to improve its business environment (table 1.1, appendix 1). The country is ranked 122 in ease of doing business and is facing numerous challenges in terms of firms’ access to infrastructure, property rights and basic services. More particularly, M/SEs are facing serious obstacles in accessing external source of funding because of their registration status (informal) and the excessive collaterals needed. That’s why they rely more on informal funding mechanisms. Moreover, the post-revolution economic crisis and political instability have worsen the situation even more and raised frustration among the population. According to the 2012 Egyptian Labour Market Panel survey (ELMPS), the number of M/SEs ownership has decreased between 2006 (26.3%) and 2012 (21.5%), especially in rural zones and the Upper Egypt region. Also the percentage of formal M/SEs has decreased by 7% during this period (Rashed & Sieverding, 2015). That’s why effective policies must be undertaken to ensure the sustainable growth of M/SEs and the formalization process.

Literature review and hypotheses

The concept of “informal sector” has been introduced by Keith Hart and the ILO in 1972 (Hart, 1973). Since then, disarrays surrounding this topic created the necessity to adopt an international definition, which have been adopted by the ILO in 1993. The national definition used by the CAPMAS is compatible with the ILO’s definition but is more restrictive. M/SEs are defined as “the ‘unorganized private sector,’ which includes; 1) retail trading activities (four employees or less per establishment); 2) manufacturing industries and repair services (nine employees or less per establishment); or 3) business entities that are not covered by law 159/1981, Investment Law 230/1989, and unregistered in neither the Commercial Registry nor its equivalent” (Abdelhamid & El-Mahdi, 2003, p.16).
The literature on the informal sector is very wide and presents several studies on its causes and consequences. Using household survey in Poland, Gardes & Starzec (2001) proved that the informal sector is multiplied in periods of crisis and reforms because it feeds the market with cheaper goods. This sector generates a sort of social multiplier; once a firm or a person joins this sector, related social stigma’s costs disappear and people become more eager to join it. Hence, they become trapped into informality. De Soto (1990)’s experiment in Peru identified government bureaucracy as the main driver of informality. Informal firms choose voluntarily to remain informal not only to evade taxes, but also because of the lack of information concerning registration procedures, as well as their fear of punishment associated to unreported payments.
Similarly, Djankov et al. (2004) showed that entrepreneurial decision in Russia depends mainly on the intensity of entry barriers in terms of corruption practices and bureaucracy. Moreover, the theoretical model of Dessy & Pallage (2001) claimed that informal firms should necessarily reduce their size to be more flexible and more capable to take risks subsequent to small innovations. In consequence, productivity and salaries are lowered because of resource misallocation and their incapacity to access credits and modern technologies. And regarding firms’ constraints to grow, Cull & Xu (2005) underlined the importance of property rights that guarantee easier access to source of funding in China. Moreover, Beck et al. (2008) identified the access to finance as the major factor that enables firms to contribute to economic development in developing countries.
Beck et al. (2005) opened the door for many researchers to study the key role of financial constraints. They showed to what extent development in the financial sector contributes to poverty reduction by supporting the growth of small and medium-sized enterprises (SMEs) in developing countries. Similarly, Cull and Xu (2005), Beck and Demirguc-Kunt (2006) and Beck et al. (2008) emphasized that financing obstacles are more growth-constraining for small firms and prevent all firms from reaching their optimal size. More recently, the World Development Report (2013) and Kuntchev et al. (2014) reported access to finance to be the most powerful constraint hindering firms growth in developing countries, and especially in Africa. They also found that the probability of a firm being credit constrained decreases with firm size, with higher productivity, and with higher proportion of private credits to GDP in the country.
In Egypt, Meyer (2000) discovered that the weaknesses of the regulatory environment is considered as one among several other M/SEs’ daily constraints. These last also consider access to finance, training, infrastructure, and technology as major constraints. As shown by El-Hamidi (2011), the size of the tax burden has a negative impact on the size of the financial capital of the firm. That’s why M/SEs access to formal financial support as formal loans and credits is considered as the main constraint facing their development due to associated costs and risks. By consequence, the majority of M/SEs move towards the adoption of other methods of internal finance as savings, inheritance and other informal sources (El-Mahdi & Osman, 2003).
Using the Egyptian Labour Market Panel Survey 1998-2006, the results of Wahba (2009)’s probit model proved that the probability of transition between the informal and semi-formal or formal sector in Egypt exists only for educated men but not for uneducated or female workers. Charmes (1990) considered the increasing rate of unemployment in Egypt as the main cause of the expansion of the informal sector that operates in the broad daylight. This fact has been confirmed by Attia (2009) who called on the importance of state intervention to draw more effective policies that allow for a more favourable business environment. Especially that informality mirrors the distortion of regulation, the lack of decent work, the underestimation of GDP and institutional distrust (African Development bank, 2006).

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Informality and productivity of M/SEs

As expected, the results of the first stage regression (table 1, column 1) show that the probability of M/SEs’ registration is negatively affected by its instrument (severity of tax administration procedures). This negative effect is highly significant and remains robust to other specifications (table 6.1 – appendix 6). Increasing the severity of tax administration procedures typically reduces the probability of M/SEs registration, which mirrors the imperfection and complexity of the institutional system in Egypt (World Bank, 2014). The second stage regression (table 1, column 2) indicates that M/SEs’ monthly labour productivity increases significantly by 71 percentage points when they operates formally. This positive effect remains valid when splitting the regression to male and female entrepreneurs (columns 3 & 4). In addition, as reported in table 7.1 (appendix 7), our regression reports a stronger positive effect when using TFP measure instead of labour productivity measure. Similarly, as reported in appendix (8) (table 8.1, columns 1 & 2), this positive effect remains valid when applying a 2SLS estimation that accounts for the binary effect of the endogenous variable (use of a probit estimation in the first step equation).
Nevertheless, this reported effect is subject to the impact of other explanatory variables included in our regressions. First of all, the gender aspect of M/SEs is an important factor that must be taken into consideration when addressing M/SEs in Egypt (El-Mahdi, 2006). Comparing to female entrepreneurs, we can first remark that being a male entrepreneurs increases the M/SE’s monthly labour productivity by 24 percentage points (table 1, column 2). Then, splitting our estimation by gender (columns 3 & 4), we can realize that female entrepreneurs operating formally outperform their male counterparts (15% gap). This result is in line with the findings of El-Hamidi & Baslevent (2010) and El-Hamidi (2011) who proved that female entrepreneur could be better performing comparing to male entrepreneurs but they generate less profits and revenues because of the barriers imposed by the market and the society. Our findings add that the performance of female entrepreneurs could be even more enhanced if they are running their firms on formal basis. Besides the gender of the entrepreneur, his/her human capital plays an important role in taking rational decisions and creating a secured capital and business (Meyer, 2000; World Bank, 2014). In contrast to the effect of formal education, the probability of registration of the M/SE increases significantly when the entrepreneur receives training or/& experience related to his/her present activity (table 1, column 1). The insignificant effect of both variables on M/SEs’ productivity (table 1, column 2) is driven by the poor provision of training programs as well as the imperfection of the education system in Egypt that pushes entrepreneurs to build their businesses based on their own experience in the field rather than formal education.
According to Mincer (1975)’s human capital theory, the entrepreneur’s revenues increase through his/her lifecycle at a diminishing rate and start to decrease when s/he gets older and when net investments in human capital become negative. Our results are in line with this theory since the entrepreneur’s age has a negative effect on the firm’s productivity. Though, age has a positive effect on the probability of registration of the firm since the experience acquired by the entrepreneur through years allows him/her to consider the advantages of operating formally and the importance of leaving a secured business to his/her inherited generation. M/SEs’ owner characteristics call on the importance of the “one man show” notion as the majority favours self-employment (Abdelhamid & El-Mahdi, 2003). That’s why having business partners has a significant negative effect on the productivity of M/SEs (-17% points). Yet, partnership may increase significantly the probability of registration of the firm because it provides stronger initial capital for the firm to cover licensing and registration’s costs.
The location of M/SEs is captured by accounting for the zone (rural or urban) and the region (Metropolitan, Upper and Lower Egypt) in which the firm operates. Comparing to rural zones and the metropolitan region, the probability of registration is higher for firms located in urban zones of Upper or Lower Egypt regions. However, the productivity of firms is not differently affected when locating the firm in urban or rural zones, and in Metropolitan or Lower Egypt regions. M/SEs’ productivity is significantly lowered in Lower Egypt region comparing to the Metropolitan region, especially due to the poor provision of services in these areas (basic infrastructure, technology, materials, etc.).

External source of finance and tax formalities

Many papers argued the importance of the financial capital for the survival of M/SEs (Abdelhamid & El-Mahdi, 2003; El-Mahdi & Ossman, 2003). That’s why we account for it in our baseline regression through the variable 𝐼𝑛𝑖𝑡𝑖𝑎𝑙𝑖 that shows whether firms’ initial capital is based on savings, inheritance or formal credits. The first two reflect the firm’s access to internal source of finance and the last reflects the firm’s access to external source of finance. Table 1 (columns 1 & 2) shows that although inheritance is the only source of initial capital that increases significantly the probability of M/SEs’ registration, it has not a significant effect on M/SEs’ productivity. However, formal credits are the only source of initial capital that increases significantly the productivity of M/SEs (+22.8% points). Yet, only 5.26% of surveyed M/SEs have access to credits in our sample.
In order to test the relationship between registration (tax formalities) and external sources of finance from one hand and between external and internal sources of finance from the other hand, we replicate our instrumental variable estimation by using the variable “credit” as dependent variable.15 As shown in table (2) (column 2), tax formalities (𝑟𝑒𝑔𝑖𝑠𝑖̂) increase significantly the probability of access to credits. However, internal sources of finance (savings and inheritance) tend to affect negatively and significantly the probability of access to credits. This result proves the existence of a complementarity relationship between tax formalities (i.e. registration at tax department and payment of taxes) and the access to external source of finance (i.e. formal credits), which indicates that tax formalities are a necessary condition to ensure M/SEs’ easier access to external source of finance. It also proves that internal and external sources of finance act as substitutes. According to appendix (8) (columns 3 & 4), these results remain valid when applying a 2SLS estimation that accounts for the binary effect of the endogenous variable (use of a probit estimation as first step equation).

Table of contents :

Chapter (1) Informality of micro and small enterprises in Egypt: A cross-section analysis
Abstract
1. Introduction
2. The characteristics of Micro and Small enterprises in Egypt
3. Literature review and hypotheses
4. Data and summary statistics
5. Methodology
6. Empirical results and discussion
6.1 Informality and productivity of M/SEs
6.2 External source of finance and tax formalities
7. Conclusion
References
Appendices
Chapter (2) Informal competition, firms’ productivity and policy reforms in Egypt
Abstract
1. Introduction
2. Stylized facts on the Egyptian economy and its informal sector
3. Literature review and hypotheses
4. Model and data
4.1 Measuring formal firms’ productivity
4.2 Measuring informal competition
5. Results and discussion
5.1 Baseline results – The impact of regional informal competition on formal firms’ productivity in Egypt
5.2 Solving endogeneity and omitted variable bias – Instrumental variable approach and IRIC dynamic effect
5.2.1 Instrumental variable approach – The 2012 presidential elections’ voter turnout
5.2.2 IRIC dynamic effect
5.3 Difference-in-difference – Informal competition and the 2005 new tax law
6. Conclusion
References
Appendices
Chapter (3) Informal Competition and productivity in Sub-Saharan Africa
Abstract
1. Introduction
2. Literature review and hypotheses
2.1 Relationship between formal firms, informal firms and economic development
2.2 Entrepreneurial capacity of the informal sector
2.3 Transmission channels
3. Data and stylised facts
3.1 Measuring formal firms’ productivity
3.2 Measuring informal firms’ competition intensity
4. Methodology and results
4.1 Endogenous switching regression model – Determining the productivity gap
4.2 OLS estimation – Determining the impact of informal firms’ competition on formal firms productivity
4.3 Instrumental variable approach – Robustness check to the positive effect of informal firms’ competition
5. Conclusion
References

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