Moving Towards Formality: The Case of the Informal Sector in Lima, Peru

In countries with high rates of population growth and urban migration, the informal sector accounts for a large part of the economic activity. According to a study by the economist Jacque Charme, the informal sector represents 50% to 70% of non-agricultural GDP in developing countries. This sector absorbs the growing need to generate income and employment for more than 2 billion people worldwide (ILO, 2018).

The International Labour Organization (ILO) defines the informal economy as the diversified set of economic activities, enterprises, jobs, and workers that are not regulated or protected by the state. This sector is described based on five facts as presented by La Porta and Shelifer (2014). The informal sector is said to be characterized by having a large share of the economic activity, low productivity, disconnection from the formal economy, tax avoidance, and shrinkage when a country grows and develops.

According to Raunelli et al. (2016), small entrepreneurs are avoidant of risks and tend to overestimate their skills, which may be a hypothesis of why entrepreneurs in the informal economy leave the market quickly. Entrepreneurship in this context might be challenging. So, the challenge for an entrepreneur is to survive in the informal sector or to be productive enough to move towards formality.

It is also important to specify the benefits of the formal economy for the players. For an entrepreneur, those are legal security, expansion capacity, and access to credit in the financial system. For the Government, it is related to monitoring and promoting the national production in small and medium sized companies, controlled and supervised employment, and increase in tax collection levels.

Converting an informal market to a formal one takes place and differs from country to country based on the laws and circumstances of each. The World Bank has identified the main drivers of informality in the Peruvian economy. Those are business and labor regulation to implement flexible labor laws, government transparency to eradicate corruption, and government spending in education, infrastructure, and social programs related with nutrition and health.

The different levels of government have specific tasks in terms of the fight against informality. In the case of Lima, the District Municipality of La Victoria has in its jurisdiction Gamarra - the largest textile commercial emporium in Peru, which generates US$ 5.6 million and receives more than 150 thousand people per day. This commercial zone has been characterized by being highly informal in its surroundings generating chaos, disorder and contamination. Mafias and illicit associations have taken over Gamarra, profiting by 'protecting' tiny spaces and charging US$ 1.5 thousand monthly per square meter on public streets and sidewalks to street sellers. Under this scenario, the new district mayor George Forsyth closed the emporium for three days to carry out cleaning, security, and control work in public spaces.

An important thing about this intervention, apart from having been successful, turns out to be the effect it has had on consumer behavior in Peru, because it questions the way in which people act and opens a new opportunity to fight against informality. In exchange for a low price, people are willing to receive a product or service of very poor quality encouraging its expansion. This may affect important areas such as transport, housing and health. The problem that many question about this aspect is the lack of better options in the market. Under the slight supervision of the state, which allows these goods and services to be offered in precarious conditions, disincentives are established for the creation of productive competition in these areas. Things may begin to change under the perspective of the consumer, who by using their market power could modify the determinants of the informal economy. But is not enough because it also depends on government intervention.

On the other hand, to improve productivity and to promote resilient, sustainable and scalable entrepreneurship, the state and the private sector have joined forces to provide venture and seed capital to encourage and support startups in financial and managerial capacity development. It has increased significantly in recent years, reaching US$ 9.8 million invested in 2018 and with growth expectations of 25% by the end of 2019. Thus, this presents an incentive to influence new businesses to operate under the law through financing, and by reducing the risk of initial operations. For established small and medium sized companies, the government is further supporting them through tax reduction measures, regulatory and administrative simplification, and passing laws to increase financial accessibility with banks.

Throughout Peru's history, informality survived due to the economic crises. Today however, as the country faces continuous economic growth, the informal sector is unable to keep up and is becoming an important factor in the increase of inequality in the country. It should be noted that according to the World Bank Open Data, Peru is rank 26th in worldwide informal economies. Thus, the cooperation between academia, state, and the private sector must continuously be strengthened on a greater scale to fully tackle this matter not only in Peru, but also in developing countries to promote inclusive economic growth.

        Paredes Ramirez, D. (n.d.). Moving Towards Formality: The Case of the Informal Sector in Lima, Peru. Retrieved April 16, 2019, from https://www.changemag-diinsider.com/blog/moving-towards-formality-the-case-of-the-informal-sector-in-lima-peru

Tax Evasion and its Impact in Peru’s Modern Economy

"Being part of the informal sector means you are outside of the legal regulations and taxation, but it also implies that you don't count with the protection and services that the state can give you"

-Hernando De Soto (1989) 

Tax evasion and informality are major challenges for Peru's economy and society. According to recent estimates, the informal sector accounts for around 70% of the country's workforce and 30% of its GDP. However, the tax evasion rate is up to 50% of the total tax revenue, which means that a significant portion of the country's economic activities operate outside the formal regulatory framework. 

This has many social and economical consequences that disrupt the components that work towards stabilization in the country and its people, including lower productivity, lower quality jobs, and higher poverty rates. The informal sector also poses significant challenges for the government, the tax administration, and other legal entities that operate for society as a whole, as it limits the state's capacity to collect revenue, provide public goods and services, and ensure social justice for all citizens. A study published in the journal Innovar (2019) suggests that one of the main causes of tax evasion in Peru's informal economy is the lack of trust in the government and the tax system. Additionally, the weak enforcement of tax laws and regulations contributes to the problem. The consequences of tax evasion in the informal sector include a reduction in government revenue, unfair competition for formal businesses, and erosion of social trust and cohesion.

 

To address this issue, many experts recommend simplifying the tax system, providing tax education and incentives for formalization, and strengthening the tax administration. Moreover, it is essential to promote a more inclusive and equitable economy that benefits everyone, leaving no one behind. Education makes up for a highly influential factor as well, since financial matters are often better treated where we find improved learning curves across different cultures and regions. As the country seeks to recover from the economic and social impacts of the COVID-19 pandemic, addressing informality and tax evasion is more crucial than ever. Peru’s informal economy manages a great deal of importance in the financial sustainability of the country as of itself, the percentage of the GDP that is represented by informality accounts for up to 37.4%, meanwhile, for the rest of the countries within the OECD (Organisation for Economic Co-operation and Development) the income represented by informality accounts for roughly 19.8%. 

Furthermore, it's worth noting that Peru collects only 52.8% of its potential revenue, which is not due to exemptions or other related phenomena but to high tax evasion, which has persisted for many years (Ramirez & Nolazco Cama, 2016). This highlights the urgent need for action to address tax evasion and informality in Peru's economy. 

Addressing tax evasion and informality is critical to promoting a more sustainable and equitable economy in Peru. By implementing policies and programs that encourage formalization, simplify the tax system, and strengthen the tax administration, the country can enhance its revenue collection, increase social trust and cohesion, and build a more resilient society for the future. 

 Origins and Evolution of Informality

 (Darle clic a la imagen)