Burden of compliance on SME growth

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THE growth trajectory of a small business as it metamorphoses from a micro-enterprise through a small and medium enterprise (SME) business to, eventually, a large business faces numerous barriers to formalisation and growth.

By Clive Mphambela

Mostly, there are the attendant costs and difficulties in formalising small businesses, which we will try and unpack in this article.

This basket of issues is now commonly known as the “cost of compliance” and plays a significant role in the decision matrix of any micro or small business that seeks to expand or formalise its operations.

A lot of research across the world, including Zimbabwe, has been done on the subject, and one thing that is clear from the research is that there exists a continuum between the formality and informality.

Even with the most formal business, very few businesses follow all the rules governing formal enterprise behaviour, and on the extreme scale of informality, for their own reasons, some businesses will follow none of the rules set for formal businesses.

The debate on formalisation has, therefore, settled on the notion that formalisation can be viewed as a gradual process that does not involve moving from one fixed state to another.

The degree of formalisation varies immensely from a business that may be registered, but not pay any taxes nor declare their employees earnings for the purpose of social security insurance.

On the other hand, a business may not be registered as a formal company with the Registrar of Companies or government, but nonetheless complying with many local authority regulations.

A 2004 fact-finding study by SIDA and other research concluded that entrepreneurs will make repeated economic calculations in the form of a cost-benefit analysis, which determines a minimum threshold of participation in formal arrangements for which the costs remain lower than the benefits, that is to say – businesses will embrace formality up to the point where the marginal costs of so doing are less than the benefits they will gain.

For those enterprises that are making a decision about their level of formality, there are certain barriers that are weighed in heavily on the cost-benefit analysis.

These barriers have been identified in a number of pieces of researches, such as the SIDA fact-finding study referred to earlier, the annual World Bank Doing Business reports which record compliance cost surveys of the informal sector.

These reports typically suggest that barriers to formalisation fall into several broad categories which include:

(i) Regulatory barriers;
(ii) Administrative barriers;
(iii) Fees and financial requirements;
(iv) Corruption in public administration;
(v) Socio-cultural attitudes;
(vi) Lack of key business
services; and
(vii) Criminality.

The first three are defined as the microeconomic and regulatory and administrative barriers to formalisation, ie (i) Regulatory barriers; (ii) Administrative barriers; (iii) Fees and financial requirements.

These, including corruption, have a direct effect on entrepreneurs’ willingness to engage with government.

There is a strong global body of evidence to suggest that the above factors, in particular corruption, have the most direct influence on the formalisation decision of small businesses.

The other factors, no doubt, play a part in the decision, but much less directly so, and economists argue that there are perhaps more barriers to growth than specifically to formalisation.

Regulatory barriers, administrative barriers and fees are closely linked and it is sometimes difficult to distinguish between them.

They are considered as generic barriers.

The specific areas where these three forces converge to give possibly the most significant barriers to formalisation are taxation, business registration/licensing requirements and compliance with labour laws.

Because of the many administrative layers required for one to go through before their informal business may be turned into a more formal one, the bureaucratic processes not only act as a disincentive for entrepreneurs, but create an incentive for the public officials to create rent-seeking opportunities for themselves.

For example, if registering a company with the Registrar of Companies takes an inordinately lengthy amount of time, it creates an opportunity for officers from that office to ask for incentives from seekers of those services to “expedite” their documents.

Another example being commonly cited in Zimbabwe is in the liquor trade where multiple stage licensing requirements are resulting in entrepreneurs being forced into side contracts with enforcement agents for them to look the other way if their licenses are not in order.

Liquor outlets are required to renew their licences every six months, but via several government and local municipal offices who reportedly sometimes take several weeks just to put a stamp on a licence document.

In these situations where time costs are converted into financial costs, the revenue from such activities goes into the pockets of the officers and not the institutions they represent.

So, services will not improve because resources are being diverted and above all the officials themselves will have very little incentive to improve services either as they benefit from the bottlenecks in the system.

The fatigue generated by the first four barriers does contribute to negative socio-cultural attitudes about formalisation of businesses.

If it becomes generally accepted that running a formal business is difficult and fraught with many pitfalls, over time people will prefer the less formal setups.
Sometimes the dearth of key business services in an area will lead to businesspeople shunning formalisation.

If the authorities are not providing essential services and infrastructure for businesses to function properly, business people will respond by also not wanting to contribute a fair share of taxes to fund those services.

They will naturally avoid the tax net.

Lastly, and sadly, some businesses simply will not formalise because their underlying business operations may not be entirely above board in legal terms.
The owners have no incentives to have a business setup that may potentially expose them to legal scrutiny.

l Clive Mphambela is a Banker. He writes in his capacity as Advocacy Officer for the Bankers Association of Zimbabwe. For your valuable comments and feedback related to this article, he can be reached on 04-744686, 0772206913, or clive@bas.org.sw.

4 COMMENTS

  1. We are an SME by the standards of SME and we honour our tax obligation but I tell you I feel for my director when he goes for tax clearance the process is taxing and I don’t see siya-so guys going through that process yet Chinamasa in his budget thinks the siya-so is the way the country is going.

  2. pliz we a the guys who work informally iyoyo siya so with this indegenisation is goin to an unexpected size we just need support zvaiitwa mafarmers ne govenment guys this is a revolution .up the black industrialisation tipei nguva not kuti discourager

  3. Its quite an interesting & sensitive issue concerning SMEs formalisation. Keep on publishing stories concerning SMEs growth since its a key issue to Zimbabwean economy. I would be glad if you can send me some stories and published articles concerning SMEs growth as it will help me in carrying out my study on factors that can promote SMEs growth. My email address is pendasebastain@gmail.com

  4. i run a small informal SME. i have been argonising about benefits of going formal. i think i need a clear write up of the benefits of formalisation other than contributing to the fiscus. the government equally has to take a risk in supporting growth of smes so that it reaps where it has sown. with more big companies closing shop these small siya so guys are filling the niches.

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