By Stephanie Jacob
The informal economy is a fixture in every economy, and sometimes even a necessity – however unchecked it can bring both economic and policy problems. KiniBiz discusses the importance of efforts to formalise the informal economy; both in terms of fair and equitable collection of taxes, and in line with providing support and developing some of the promising businesses that currently function in the shadows.
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The legal segment of the informal economy encompasses a whole range of diverse and varied activities across many industries. Also known as the unregulated or underground economy, like the illegal portion, it is difficult to measure both in terms of size and value.
Unlike in the illegal segment though, where both buyer and seller are almost always aware that they are trading in something illicit, those dealing with businesses in the legal segment of the informal economy, often do not know that the businesses they are patronising are technically running afoul of the tax and regulatory laws of the land.
An example of an illegal economy will be when one buys a pirated DVD copy of the latest Hollywood movie or a counterfeit version of a football jersey, while an example of an informal activity would be a food stall owner, or your neighbourhood mechanic – both of which are legal commercial activities.
However, although the informal economy consists of commercial activities that are all legal in nature, the fact that those participating in and running the businesses do not pay taxes and usually are not registered or licensed by any local authority, means that technically they are breaking the law.
Why does an informal economy develop?
The informal or underground economy is ever present at all levels of economic development – in a developing economy, smaller enterprises initiate the informal sector to support the larger ones. They provide job opportunities and even help facilitate poverty eradication.
In developed countries, rising electronic transactions for example, have accelerated e-commerce sales, which being difficult to track and regulate, has resulted in a rise in non-tax compliance in those economies, according to a journal article written by Marliza Mohamed for the Malaysian Journal of Economic Studies.
However it is important to note that the role of the informal economy, especially in the economies of developing nations, is sometimes seen as a necessary problem and one that even helps, in the sense that it can provide an income lifeline and jobs to those not able to access the formal economy, said the article.
Nonetheless, over time, an unchecked informal economy can begin to outweigh the positive impacts, and start to take a negative toll on both public finances and policy creation, said Maliza.
This would explain why there needs to be a conscientious effort to monitor, and ultimately incorporate the sector into the formal economy.
A research paper published in the Business and Management Review, titled Underground Economy: Definition and Causes, highlighted several factors as reasons that could be seen as causes for the development of the informal economy.
Firstly, there is the government – or more specifically what is seen as government inefficiency, along with trust issues that people seem to have with their government.
The article also noted that regulatory issues, in particular intensive or seemingly corrupt regulations, a slow moving legislative system, and concerns over one’s equality under the law were common issues that drove the informal economy.
Taxation rates and economic issues were also highlighted as other factors that contributed to the underground economy. High tax rates, economic recessions, high unemployment and slow economic growth were all issues that encouraged the informal sector.
Broadening the tax base by formalising the informal economy
While the exact size of the informal economy is hard to gauge, a study done by the Department of Statistics in 2012, titled ‘Informal Sector Workforce Survey Report’ suggested that 8.2% of the total employed workforce in 2012 was hired in the informal sector.
Several criteria was used to determine informal sector enterprises, the first being that the business was not registered with the Companies Commission of Malaysia or any other professional body, including the Local Authority; they also had to offer at least one, or all of their goods or services for sale or barter, and the business could not be more than 10 persons large or registered under any form of specific national legislation.
Using these guidelines, the survey concluded that the informal legal sector employed one million of the entire 10.9 million strong employment force (non-agriculture) in Malaysia. With results showing that a majority of these workers worked in urban areas; in a variety of industries, with construction being the largest among them.
While the survey stopped short of providing specific figures as to the total value of tax revenue lost from the non-compliance of these workers, one assumes that at least a portion of those surveyed should be contributing taxpayers, which means that the country is losing revenue and the tax burden is being unfairly borne by a smaller portion of Malaysian workers than it should be.
In a research paper titled ‘How Can Domestic Resource Mobilisation (DRM) Through Taxation Help Reduce Poverty and Inequality’, Lim Hong-Eng noted that the country relied heavily on taxes to fund development and operational expenditure, stating that most of the country’s tax revenue came from petroleum-related businesses and the salaried group (in particular the middle income taxpayers), and asked if all Malaysians were paying their fair share of taxes.
Lim highlighted that one area in which the country lost tax revenue was from the informal or underground sector, which pays no tax at all, and went on to opine that a more comprehensive system be put in place, suggesting back then that the government introduce a consumption tax, to shift the focus of tax collection from being income-based, to being consumption-based.
This measure was recently taken when the government announced that it would introduce a goods and services tax in 2015. Tomorrow we will look at how GST could help the government deal with the issue of recouping the revenue lost as a result if the informal economy.
The questions however, as to why those in the informal economy might feel that they are exempt from having to contribute taxes, and if it is due to them being unaware of the tax laws is unclear.
Soh Lian Seng
Tax experts however dismiss ignorance of the law as the reason, and KPMG Tax Services Sdn Bhd’s executive director Soh Lian Seng scoffs at the suggestion that those in the informal economy do not understand the tax rules or are unaware of their responsibilities. He said “to be fair to the IRB, they have done many awareness campaigns, and during tax periods are active in opening up booths and information centres in the malls even…there are plenty of opportunities for people to get more information.”
While saying that along with strengthening the IRB in order to allow them to better enforce the tax laws, he agreed with the idea that a law such as GST may be what is necessary to allow a more efficient tax collection system in the country.
Taking informal businesses to the next level
Along with widening the tax net to ensure that all Malaysians contribute their fair share of taxes, another benefit of formalising the underground economy will be the ability to strengthen and improve what are sometimes very promising businesses operating in the underground economy.
As such SME Corp is actively working towards formalising the underground economy, with one the four key goals in its SME Masterplan being to reduce the informal sector (both legal and illegal) from the 30% plus of the Gross National Income it currently stands at, to 15% by 2020.
According to the SME Corp, “the aim from a policy perspective is to bring the informal economy into the mainstream so that these firms can be nurtured and given the appropriate support to grow their business.”
The High Impact Programme 1 has been introduced, which aims to integrate business registration and licensing to ensure that registration is a prerequisite for the licensing of new businesses, said SME Corp.
It also added that it will continue to work together with the relevant governmental ministries and agencies to incorporate existing informal businesses to targeted and specific formalisation campaigns to help them grow their businesses more effectively.
Yesterday: The black economy
Tomorrow: GST and strict enforcement the way forward?
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