The Entrepreneur. Household business (ho kinh doanh ca the) without tax code. Formality

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1 ADB A summary of research work from Making Markets Work Better for the Poor No 02 Private Enterprise Formality and the Role of Local Government Research Questions * Are owners of small off-farm businesses more likely to operate formally, that is,i.e. register as companies, in some provinces more than in others? Can lessons be learned from provinces in the former group where businesses do operate more formally, to help stimulate greater development and formalization of private enterprise in the latter groupprovinces where businesses are less likely to operate formally? Hypothesis Business environments vary from province to province, making it more or less attractive for enterprises to operate formally. Provincial governments have the power to shape these environments. Figure 1: The Entrepreneur's Decision: Which Degree of Formality? The Entrepreneur Fully unregistered business (most commonly individual entrepreneurs) Production Unit or other form of business registered at ward-level Household business (ho kinh doanh ca the) without tax code Household business with tax code Company (sole prop., Partners, Co Ltd., Or JS Co.) Formality What is Formality? The formalization of non-agricultural enterprise is the process of bringing businesses under a predictable, comprehensive system of law and administrative measures. In this study, companies are defined as relatively formal and household businesses as relatively informal. The rational is that the existing regulatory framework for the latter in Viet Nam is less comprehensive, less transparent, and less strictly implemented and enforced. * This paper is derived from MMW4P's Discussion Paper No 2 Private Enterprise Formality and the Role of Local Government based on a study conducted by Pham Thi Thu Hang from Viet Nam Chamber of Commerce and Industry (VCCI) and Markus Taussig. 1. The words process and relative are key. More informal enterprise types include to san xuat (production unit), to hop tac (cooperative unit), and trang trai (farm), as well as independent individual entrepreneurs (e.g., mobile sellers) who are not registered at all.

2 Figure 2. Main Benefits and Consequences of Formalization in Viet Nam Economy Enterpris e Main Benefits Increased standardization of regulation of labor conditions and environmental impact Increased clarity in division of government responsibilities, especially at local level Increased information inputs for policy analysis and formulation Greater investor confidence leading to increased mobilization of capital Increased revenues into national tax system Right to legally access broader markets (i.e., trade beyond district) Right to legally employ more than 10 workers Stamp for making transactions more official Value-added tax receipts Right to set up branch establishments More predictable, law-based relationship with the Government Ability to access equity capital (Ltd. & JS Companies only) Greater access to government investment incentives Main Consequences Increased responsibilities for the Government, especially local authorities (straining existing capacity) Greater costs of registration (and required public announcement) Annual registration fee (thue mon bai) Requirement for certified chief accountant Increased state reporting requirements Increased restrictions due to labor contracts Potential for increased attention from local authorities (regulators) Potential for increased taxes (with move from lump sum to standard tax calculation) Methodology of the Study This paper is based on an analysis of three main sources of information. 2 1 The Big Picture Documents and statistics on private sector and small and medium enterprise development 2 Similar Cases A database of firms with tax codes in 14 provinces 3 Dissimilar Cases A survey of enterprises, financial institutions, and officials in six provinces 3 The Big Picture: Macro and Micro The number of private companies increased dramatically under the Enterprise Law, and company employment is likely to surpass that of state-owned enterprises (SOEs) by Despite this, gross domestic product (GDP) shares of the formal private and state sectors have not changed over the past decade. A possible factor is the World Bank Group s suggestion that the shadow economy may have grown by two thirds from 1997 to State Households and Individ FDI Collectives Private Companies Figure 2: GDP by Ownership Form, For more details on methodology and other components of the study, contact Markus Taussig at markustaussig@mac.com and/or Pham Thi Thu Hang at vcci@smelink.netnam.vn. 3 Sample: 120 companies, 120 household businesses, 50 credit institutions, and 96 state offices in 6 provinces. 4 Based on 2002 enterprise numbers and growth rates. 2

3 2001 and may now add more than 50% on top of formally calculated GDP SOEs Ltd. & JS Cos. Sole Proprietorship Cos. Industrial Household Businesses Services Household Businesses SOEs Ltd. & JS Cos. Sole Proprietorship Cos. Industrial Household Businesses South Central North Off-farm household businesses have also grown in number. Household firms in industry alone increased by over 100,000 from 2000 to This substantial growth in industrial firms outside the company sector indicates a decline in overall enterprise formality. Such informality is most significant and growing most rapidly in the North. Services Household Businesses ,000 1,250 (thousands) Figure 3: Employment by Ownership and Region, 2000 and 2002 Formality across Provinces General Statistical Office data shows that, at the provincial level, a higher share of household businesses (HHBs) in industry correlates with lower frequency of sole proprietorships (Figure 4). Comparison with tax data shows a higher share of HHBs in industry also correlates with lower share of household firms with tax codes (Figure 5). A lower share of HHBs with tax codes, in turn, correlates with a lower share of total private enterprises registering as companies (Figure 6) Bin h Du o n g.8 Kien G Bin h T h u a n Southern provinces iang Ben Tre Figure 4: Sole Proprietorships and Industrial HHBs.6 Bac Lieu SO LEPRO P Dong Nai.4.2 La n g So n Ha Tay So n La Thai Binh Bac Giang Ha Nam 0.0 Rsq = Dak Lak.2 IND_HHES Thua Thien Hue.3.4 Northern Ninh Binh provinces Qu an g Bin h Figure 5: HHBs with Tax Codes and Industrial HHBs 5 Estimate is based on the World Bank s macroelectric model, a method that has been used to understand informality in Eastern Europe and the former Soviet Union (see Stoyan Tenev, Amanda Carlier, Omar Chaudry, and Quynh-Trang Nguyen, Informality and the Playing Field in Viet Nam s Business Sector, International Monetary Fund, World Bank, and Mekong Project Development Facility, Washington, DC, 2003, p. 15). The larger overall GDP figures, however, are rarely referred to in other World Bank analyses. 6 Variables in the three graphs in this section include: (i) IND_HHE = industrial household businesses/total household businesses; (ii) SOLEPROP = sole proprietorships per thousand local residents; and (iii) HHE_FORM: household businesses with registered tax codes 6 /total household businesses; and (iv) PS_FORM: total private companies/ (total private companies + total household businesses). 3

4 Figure 6: HHBs with Tax Codes and Formality These findings indicate that industrial HHBs reflect negatively on the attractiveness of formalization in the local business environment. The findings also imply that broader reach on behalf of tax authorities may decrease incentives for registering an industrial enterprise as a HHB. Formality and Economic Governance A clear relationship was not established between provincial governance and formalization through bivariate analysis of The Asia Foundation (TAF)/VCCI governance index and the formality measures used in the previous section. 7 A strong relationship, however, was found when analysis was limited to southern provinces: the higher the governance quality, the greater the formality in the HHB sector (Figure 7). 8 The inability to find a similar relationship in the north may be partly explained by the relative lack of variance in formality across provinces in the region Binh Duong Case Studies in Contrast: Survey Findings Thanh Hoa is home to a high number of HHBs, including industrial firms with as many as 100 workers. Relatively few companies in Thanh Hoa have less than 10 workers. Thanh Hoa sole proprietorships were by far the largest in the survey. On the other end of the spectrum, sole proprietorship companies with less than 10 workers were the norm in Ca Mau, while HHBs with large employment numbers in industry were relatively rare. GOV_ NDX Lo n g An 32 Rsq = HHE_FORM Ba Ria Vu n g Tau Dong Nai Binh Thuan Figure 7: Gov. Score and HHBs with Tax 7 Simple bivariate analysis of the subindexes that make up the overall index was also done, but no significant relationships were found. The index presently covers 14 provinces 5 in the south and 9 in the north. For more on the nature and substance of the governance index, see forthcoming Asia Foundation/VCCI paper by Malesky. 8 Similarly, strong correlation was found between southern governance and share of household firms with tax codes. 4

5 Thanh Hoa and Ca Mau entrepreneurs were also on opposing sides on whether a manufacturing business with 11 to 12 workers is more likely to register as a HHB or a company. Thanh Hoa is most likely to call it a household business and those in Ca Mau most likely to refer to it as company. Ca Mau was also where former SOE managers were most likely to have switched to company ownership, while no such cases existed in Thanh Hoa, thereby emphasizing the differences in the appeal of the formal private sector in these provinces. Summary of Findings The data analyzed in this study shows clear and substantial variation in the formality of private enterprise across provinces in Viet Nam. The extreme cases of Thanh Hoa and Ca Mau show that businesses of the same size differ in their decisions on whether to operate them as companies, depending on their location. Particularly striking is the degree to which provinces in the south tend to be more formalized. Even after implementation of the Enterprise Law, regional differences are reflected in the southern provinces higher shares of small enterprises in the company sector, higher shares of HHBs with tax codes, and lower incidences of HHBs in industry or with large numbers of employees, as well as a greater sense among southern entrepreneurs that company registration is appropriate for small business. Given the lack of regional governance structures, such regional differences introduce culture and history as possible significant influences on the formalization process. The study also found clear correlation between more comprehensive coverage of private enterprises by local tax officials and greater private sector formality. It can be concluded that a more uniform application of tax policies to a broader range of private enterprises particularly small industrial ventures makes them more likely to formally register as companies. The correlation of formality with more favorable evaluations of provincial governance (although only in the south) implies that a more even-handed approach in other areas of enterprise regulation may also have this same impact. The study, however, does not establish clear proof of causality that broader application of regulations leads to greater formality. It is conceivable, for example, that cultural characteristics might make entrepreneurs in some provinces more likely to operate formally as companies and also might make the remaining entrepreneurs operating as HHBs more likely to register for tax codes. Recommendations Despite the lack of a clear causal relationship, it is still possible to draw lessons from the study in relation to economic governance at the central and local levels. For central Government: the relationship of more uniform business regulation with formality underscores the importance of clearer, more concise, and targeted national laws. Complicated, broad, or vague laws are more likely to be interpreted in significantly different ways across provinces in Viet Nam s highly decentralized system. The success of the Enterprise Law in creating a uniform registration system and, thereby, stimulating growth of companies and wage jobs in areas that had previously struggled, is a prime example of how this can work. Viet Nam s complicated tax regime has improved in recent years but would still have significant room for improvement. For provincial governments: the relationship between broader enterprise regulation and formality emphasizes the value of transparent implementation processes that deal objectively with all enterprise forms, limiting decisions on which firms need to be regulated. Such a broadening of regulation must be distinguished clearly from an intensification of regulation. The latter would not only frighten the business community and discourage investment, but would also further limit local authorities capacity to attract investors. 9 The study showed the benefits of reducing differences and subjectivity in the way local officials apply the national tax regime across the different types of enterprise ownership. 9 Participants in the final workshop of this project were highly concerned that a critique of insufficient enterprise regulation would be taken to justify increased inspections and harassment of existing formal companies. 5