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Tackling SME informality:

a practitioner’s toolkit

By Nathan Smith

Ukraine and many of its neighbours in eastern Europe and the former Soviet Union have made great strides towards functioning market economies over the past 30 years. They have successfully emerged from the structural shocks of the 1990s to take their places as players in the global marketplace. But COVID-19 has shone a light on the challenges that still remain.

Many businesses, and small and medium-sized enterprises (SMEs) in particular, had to close or have fallen into informality (i.e. self-employment) as a result of the pandemic. This will, in turn, impact future tax revenues and social security payments, increasing the existing problems in these areas.

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The Ukrainian Government and its neighbours in the region can mitigate the economic challenges and build resilience by increasing the level of formality in their economy. The size of the informal or shadow economy in Eurasian states remains significantly higher than in western economies.  In Ukraine, for example, the International Labour Organisation (ILO) estimates that undeclared or informal work accounts for 21% of total employment. This situation is ultimately damaging for both state authorities and small and medium-sized enterprises themselves.

 

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Disadvantages of informal work for SMEs:

  • slower growth – informality blocks their access to formal credit, which hinders longer-term SME growth 
  • insecurity – informality leaves SMEs without a safety net (e.g. unemployment benefit) in case of difficulties.

Disadvantages of informal work for the state:

  • lower revenues – reduction of tax receipts due to smaller tax base
  • increasing deficits in the social security system
  • a more unstable labour market.

How can governments encourage SME formalisation?

Below, I outline a number of tools which governments have at their disposal to achieve this. These tools are drawn from my experience working in Ukraine, but many are relevant across Central and Eastern Europe.

 

Steps to SME formalisation

Labour market legal and regulatory framework

Governments can begin with the legal and regulatory framework which sets out the ‘rules of the game’ for the labour market and provides clarity for all SMEs. This framework should be fit for purpose and aligned to the principles of a market economy. It should also be flexible enough to allow businesses to grow and flourish.

In Ukraine, for example, the labour code contains a number of articles which are no longer in line with international good practice. Prescriptive articles setting out when a female employee must take maternity leave and unclear provisions on an employer’s right to dismiss an employee open the door to ambiguity and dispute. Labour disputes are the third most frequent type of case in the Ukrainian judicial system. All of this suggests that the existing labour market framework is outdated and not properly equipped to meet the current needs of the local business environment. This does not incentivise SMEs to formalise. A new framework law, reflecting the current reality of the labour market, would serve a number of purposes, including:

  • providing a realistic framework within which labour relations can function
  • setting out a solid basis for labour relations
  • striking a balance between preserving, and even augmenting, the rights and benefits of employees
  • providing employers with the flexibility they need to run a business effectively.

This type of framework can benefit a country’s labour market. One of the factors often cited for enabling Estonia to recover from recent crises (e.g. in 2008-9) faster than its neighbours is the flexibility of its labour market regulation. The more flexible and the clearer the regulations are, the more options entrepreneurs have to adapt to and recover from financial shocks and begin to grow their businesses again.

Targeted policy incentives

Once a functional labour market framework is in place, governments may consider specific ‘incentive’ measures to encourage SMEs to formalise. These measures should tackle some of the principal drivers behind SME informality, which include high taxation, complex business regulations and social security contributions. There are a number of policy tools which can be employed to achieve this.

  • Targeted fiscal measures: Potential measures could include tax breaks for a set period of time, with amnesties for businesses that register during this period. Governments may also consider an overall simplified tax regime for SMEs. Ukraine, for example, has already had success in introducing simplified tax regimes to encourage the formalisation of economic activity in the past. Over 600,000 Ukrainians have taken advantage of the lower tax rates to register as Single Entrepreneurs, paying only 5% tax rather than the 18% paid by standard rate tax payers. Armenia and Azerbaijan have also introduced selected forms of tax exemption for SMEs with certain characteristics (e.g. innovative, digital-focused) or operating in selected sectors.
  • Regulatory simplification for new or formalising SMEs, such as making the amount of social security contribution for an employee independent of their wage level (i.e. as a percentage of SME revenue rather than employee salary, thus putting less pressure on the employer-employee relationship).
  • Welfare bridges: in order to encourage economic activity among those individuals who rely on state benefits for survival, governments may choose to provide these individuals with a small start-up grant to help them launch their economic activity and compensate them for the loss in benefits. This approach has been tried with some success in several Eastern European contries, including Czech Republic, Hungary and Slovakia.
  • Special regimes for particularly precarious areas of work and/or sectors where high levels of informality can be observed e.g. construction, domestic working. There are a number of options here, including:
  • Setting up a specific work regime for workers who work for low wages up to a certain number of hours per month, as is now the case in Slovenia (the ‘small work’ regime). Eligible workers pay reduced rates of tax and social security and do not need a contract, as long as they are registered with the state.
  • Setting up a legal structure that would act as the formal ‘employer’ for workers who typically work for more than one entity or individual, like casual construction workers. The entity would ‘supply’ the services of these workers to employers and would pay the workers, and pay taxes and social security on their behalf.

Support and sanctions

Policy incentives are more likely to be successful if implemented in parallel with other types of measures. Governments should give thought to how they encourage compliance with labour law among SMEs, using a blend of education, capacity building and sanctions.

  • Education: State labour bodies have a key role to play in working with SMEs to make sure they understand the new regulations, as well as the benefits they can bring. This could take the form of workshops, training sessions and seminars on specific aspects of the new framework.
  • Capacity building: Beyond awareness, governments can help ensure SMEs have the skills to actually implement the new regulations. This could become part of the labour inspection process, encouraging and guiding SMEs to meet higher standards. For example, if a particular SME is struggling with one or more aspects of formalisation, the State Labour Service (SLS) could provide concrete assistance or guidance to that business.
  • Sanctions: In parallel, governments may wish to set out a clear regime of sanctions which would be applied to any SME found to be operating informally after a set amnesty period. This should be communicated clearly to the business community and done closely with the SLS to implement them properly.

These measures, when combined with the policy incentives set out above, have the potential to drive higher levels of formality among SMEs. Educational and upskilling efforts can help policies reach wider audiences in a more efficient and effective way.

Benefits of formalisation

These different policy tools represent a holistic response to the challenge of SME informality and should, in the medium-long term, drive benefits for both SMEs themselves as well as for government and the economy. Among these benefits:

  • clear ‘rules of the game’ resulting in fewer lawsuits relating to labour issues
  • formal SMEs will be able to access credit tools and state assistance, and should grow and flourish as a result
  • the state, with more tax revenues and social security wealth at its disposal, will be able to improve their service offering to citizens and businesses
  • increased economic growth as a result of increased SME engagement in the economy.
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Realisation of these benefits is starting to be seen across the region. Georgia has seen steady economic growth over recent years, and, as a result of its SME Development Strategy, has made “impressive strides in the operational environment for SMEs.” As a result, it now sits in the top-10 in the World Bank’s Doing Business report for 2020, and its levels of Foreign Direct Investment are higher than those of many of its neighbours. Azerbaijan and Armenia have both taken steps to improve the fiscal situation for SMEs and to facilitate access to finance. And Ukraine is embarking on a new SME development strategy, supported by a new office set up for this purpose.

These positive steps hint at a positive trend in the region, with countries beginning to realise benefits from increased engagement with the SME sector. It is to be hoped that governments will continue their efforts in this area, using a range of policy tools to encourage SME formalisation to the benefit of government, businesses and the wider economy.  

 

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Nathan Smith

Senior Manager, PwC Ukraine

+380 44 354 0404

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