Chapter one

Introductions

1.1 Background of the study

Informal business sector can be defined as comprising of activities of petty traders operating in
the street of main urban centers, Most are involved in the sale of second hand items like clothes,
some in the business of shoe shining, street vendors carpentry, vegetable selling, repair and
construction work. It can be also described as income generating enterprises that operate on
small scale using simple skills and are not tied any government regulations. The informal sector
mainly operates on small scale on subsistence level with fewer employees, though most are
really just self-employed individuals.

In Ethiopia these informal business sector mainly characterized by no book of account, labor
intensive, not licensed and unregulated and competitive market. As the World Bank report
indicate that, 26% of those employed in Addis Ababa work informal business, with majority of
self-employment and low productivity, the informal sector business activities are not regulated
by laws or taxations and not monitored for inclusion of GDP. In fact, there may be a number of
factors that are contributed for the rapid growth of the informal business in Ethiopia but the
major reasons are accounted for unemployment and Urban migration, the impact of this
expansion of informal business are much strengthening in the area of government revenue, tax
compliance, state legitimacy and e.tc

1.2 Statement of the problem

Most of under developed and developing countries like Ethiopia economy are very challenging
by the presence of highly accelerated growth of the informal business sector. Even though
informal business may have a little advantage through absorbing the unemployment population,
but due to its characteristics described by mobile nature of the operator, absence of premises,
high tax collection cost and absence of data and information it is very complex to tax the sector.
However, ignoring the informal sector activities lower tax payment morale and increases the risk

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of tax non-compliance in the formal sector, in which the formal tax payer perceive the state as
being unfair by non-taxing the informal sector. Therefore the study will be analyze the impact of
the growing of informal business on tax compliance behavior of formal business and also
recommend possible ways to formalize the informal sector and reduce noncompliance. In
addition, efforts will be made to identify how formal business act contrary to the tax system due
to the expansion of informal sector.

1.3 Objective of the study

1.3.1 General objective

The overall objective of the study will be to identify the causes for the expansion of informal
business and how tax payer’s noncompliance with existed tax system due to the informal sector
expansion.

1.3.2 Specific Objective

In order to address the overall objective the research will address the following specific
objectives:

 To identify the major business area affected by the informal sector

 To examine the tendency of tax non complying of formal business with tax system
 To identify major effects of illegal trade on formal business owners.
 To identify illegal activities performed by legal traders due to the effect of
informal traders.
 To stare the possible way of action taken on the expansion of informal sector and
reducing noncompliance.

1.4 Hypothesis
 There is significant interaction effect between expansion of informal business sector and
tax system.

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 1.5 Significance of the study
The paper will help in providing information about the causes that lead informal business
expand. It will also have a value in providing the way how the government reduces expansion of
the sector in order to establish fair tax system and reduce tax noncompliance from the formal
business operators; beside this major importance it will provide a better understanding to
individuals in business and other fields, which are not familiar with the financial sector.

1.6 Scope (Delimitation) of the study

The impact of informal business expansion is wide and complex on one’s country economy and
tax system. However, due to the constraints of time and resources may face; the study will focus
on the effect of informal business sector expansion on tax system compliance.

To come up with effective research result and the activities and type of the business performed
by the informal trader’s similarity, the study will be conducted in Addis Ababa City.

1.7 Organization of the paper

The final paper study will have four chapters; the first chapter will be introduction of the study
which will reflects back ground of the study, statement of the problem, objective of the study,
significance of the study, scope of the study and organization of the paper.. The second chapter
of the paper will discuss related literature review. The third chapter will deals with methodology
of the study, finally the last chapter of the paper will be conclusions and recommendations.

Chapter two

Related review literature

2.1 Introduction
The informal sector is considered as employment which is unregistered and operates outside of
the regulated formal economy. There is no common or single definition of the informal sector.
Some consider the number of employees engaged in particular informal activity while others
take the volume of capital deployed (YitbarekTsige, 2001, pp. 7-8). Thus, an indicative

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definition which is appropriate for the respective socio-economic environments are used.
However, in the majority of cases micro-enterprises and informal sector activities are used
interchangeably (Addis Ababa City Administration, July 2000, P.2). According to International
Labor Organization (ILO) informal business is defined as “all small-scale activities that are
normally semi-organized and unregulated, use simple labor-intensive technology undertaken by
artisans, traders and operators in work sites such as open yards, market stalls, undeveloped plots,
residential houses and street pavements... not legally registered and in most cases not have
licenses from local authorities for carrying out businesses”

Informal sector actors are independent self-employed individuals who produce and distribute
goods and services largely in urban areas. Some of the small scale operators employ family labor
and/or a few hired workers or apprentices. The low capital base and the low level of technology
utilized have made them to be less productive. As result, they can only obtain very low and
irregular incomes from their unstable employment. Informal sector operators do not have easy
access to organized markets, credit institutions, formal education and training institutions, or to
many public services since they are not recognized and supported by the government. They
generally work and live in underdeveloped parts of urban areas. Since they operate outside the
framework of the law, they do not enjoy social and legal protection at the work place.

2.2 The Size of Informal Sectors in Developing Countries

The informal sector has been expanding as more economies have started to liberalize. This
pattern of expansion began in the 1960s when a lot of developing countries didn’t create enough
formal jobs in their economic development plans, which lead to the formation of an informal
sector that didn’t solely include marginal work and actually contained profitable opportunities.

In the 1980s, the sector grew alongside formal industrial sectors. In the 1990s, an increase in
global communication and competition lead to a restructuring of production and distribution
often is relying more heavily on the informal sector. Over the past decade, the informal economy
is said to account for more than half of the newly created jobs in Latin America. In Africa it
accounts for around eighty percent. Many explanations exist as to why the informal sector has
been expanding in the developing world throughout the past few decades. It is possible that the

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kind of development that has been occurring has failed to support the increased labor force in a
formal manner. Expansion can also be explained by the increased subcontracting due to
globalization and economic liberalization. Finally, employers could be turning toward the
informal sector to lower costs and cope with increased competition.

According to SIDA, the key drivers for the growth of the informal economy in the twenty-first
century include:

 limited absorption of labor, particularly in countries with high rates of population or

urbanization
 excessive cost and regulatory barriers of entry into the formal economy, often motivated
by corruption;
 weak institutions, limiting education and training opportunities as well as infrastructure
development;
 increasing demand for low-cost goods and services;
 migration motivated by economic hardship and poverty; and
 difficulties faced by women in gaining formal employment

The average size of the informal economy, as a percent of official GNI in the year 2000, in
developing countries is 41%, in transition countries 38% and in OECD countries 18%,
(wikipedia2013). Some studies estimate that informal businesses account for 35-50% of GDP in
many developing countries; the informal sector is quite large, estimated at 34.3% and accounting
for 77% of employment statistics.

More specifically, the trend in both the informal and formal sector employment indicates
positive outcomes of some of the employment creation strategies adopted in the country. These
may have facilitated the expansion witnessed in the informal sector employment .The formal
sector growth over the last decade cannot be said to match that of the informal sector.

2.3 Motives and causes for expansion of informal business

The majority of analysts have agreed, to a large extent that one of the foremost causes of the
development and tenacity of the informal economy is the recession in which any country may go

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through. As a consequence of this potential stagnation, a lot of unpleasant economic phenomena
appear to happen, such as unemployment, depreciation of capital, etc., which in turn influence
the informal activities. Some of the earliest primary reasons to participate in the underground
economy mentioned in the literature are: (1) to evade taxes; (2) to avoid losing government
benefits; (3) to circumvent regulations and licensing requirements; (4) a reaction by both firms
and individual workers to the labor unions; and (5) the impact of international competition

In broader terms, the motives for participation can be economic and noneconomic. The economic
reasons are related to unemployment and an inflexible formal labor market; the declining real
price of capital; and the high cost of formal production. The non-economic motives are related to
a greater flexibility and greater satisfaction in work; a complete use of their professional
qualifications; and the increased leisure time. A very important element, which motivates the
participation in the informal economy, seems to be the role of the State. The last but not the least
reason for participation in the informal sector, mentioned by several researchers, is the
governmental over-regulation of the market sector, for example ‘not only via the taxes, but also
through labor legislation and legislature relating to labor conditions, quality regulations, and
production limitations’. This over-regulation increases the transaction costs of participation in
the formal economy, so that it becomes relatively more appealing to switch over to the informal
sector.

2.4 Informal business in Ethiopia

Informal businesses in Ethiopia are defined based on three criteria: no book of accounts; no
License: and fewer than 10 employees, (World Bank 2007c & CSA2005). Registration is a first,
but not yet, sufficient step towards licensing. Based on official statistics, 26% of those employed
in Addis Ababa work in informal businesses, with another 4.8% reported as unpaid family work,
other Employees, or so called domestic workers engaged in sales, machine operating, trade,
clerks, and official work.

The sectors wholesale and retail trade, hotels and restaurants and primary Production activities
are over 90% informal, measured as a share of employment. Businesses do not only face
informality in being unlicensed, but also in accessing informal land housing and credit. In Addis

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Ababa, these various levels of informality often coincide, land. These multiple layers of
informality indicate that informal businesses are excluded from basically all forms of
government support.

2.5 Informal Business Sectors and Taxation

Available literature indicates that there is a strong relationship between the informal sector and
the inability of the Government to collect the requisite taxes. From the informal sector point of
view, tax evasion is driven generally by a perception that the tax burden is too high. This poses a
number of problems to tax systems, raising difficult questions over how tax policies and tax
administration may influence tax compliance incentives and behavior.

The compliance tax burden on the Informal Sector may be high relative to that of large
companies (higher unit cost in relation to turnover). Further, the cost of complying with a given
set of tax rules/regulations is generally higher for the Informal Sector as a percentage of turnover
or profit. In theory, a taxpayer’s incentive to comply with a tax system depends on an assessment
of the relative benefits and costs of complying versus noncompliance.

Indeed, the large numbers of SMEs, their high turnover rates and their sheer diversity present
challenges to all administrations. For SMEs, key considerations are to minimize administrative
costs while ensuring compliance. To this end, the informal sector offers a great opportunity to
expand the tax base. The intention of bringing the informal sector into the tax net is to facilitate
the transition of these businesses to the formal sector and reduce barriers for all businesses. This
is contrary to popular belief that it is meant to stifle its growth.

Exploring opportunities to formality may create new avenues for the poor to realize their
potential and registering the drivers and Impacts of operating in the informal economy .

2.6 Is informality all about taxes?

Inducing firms to register so that they pay taxes is an important motivation for governments. But
authorities need to take more than tax collection into account. First, the failure to enforce formal
status among very small firms risks creating a norm of avoiding taxes even among those small
firms that eventually become much larger.

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This can affect tax receipts over a longer period of time, and even among larger firms in the
formal sector. Second, low enforcement among the smallest firms can actually encourage firms
to remain small in order to continue operating under the radar of the authorities. This can stifle
growth in what could be a very dynamic slice of the economy. Third, avoiding formalization
may contribute to a more widespread culture of mistrust of government, and this can spill over
into other aspects of economic, social and political life. Therefore, governments need to think
beyond the short-term calculation of ‘tax collection less costs of collection’.

Firms will of course carry out their own cost-benefit calculations. The benefits of being formally
registered include avoiding fines for operating informally, access to public goods available only
to legal entities (e.g. business courts) and the ability to bid on government contracts. The costs,
on the other hand, include the initial registration fees (and time), and ongoing tax payments.
However, it is worth noting that, especially in low income countries, a formal enterprise is
unlikely to pay all of the tax it owes. In most countries with a substantial informal sector, for
example, a large proportion of the transactions is in cash, and is therefore often left
underreported or even unreported altogether even by formally registered firms.

The tendency of small firms to remain in the informal sector may have an even more pervasive
detrimental impact on growth than immediately meets the eye. Small firms can undoubtedly
avoid taxes by keeping costs and revenues off the books. However, these efforts may make it
more difficult for them to understand the true costs of production. The accounting systems that
are typically employed in this endeavor mean that many costly errors in pricing can be made.
This results either in lost business, because products or services are priced too high, or in lost
income, because they are priced too low. Focusing on avoiding taxes and remaining in the
informal sector can often distract firms’ attention away from important growth opportunities.
Taxes, of course, may discourage some economic activity, but the problem in low-income
countries is not over-taxation but under enforcement

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 2.7 Tax Compliance behavior and attitudes
Tax compliance is a complex term to define. According to Brown and Mazur (2003), tax
compliance is multi-faceted measure and theoretically, it can be defined by considering three
distinct types of compliance such as payment compliance, filing compliance, and reporting
compliance. These categories are administrative compliance and technical compliance where the
former refers to complying with administrative rules of lodging and paying otherwise referred to
as reporting compliance, procedural compliance or regulatory compliance and the latter refer to
complying with technical requirements of the tax laws in calculating taxes or provisions of the
tax laws in paying the share of the tax.

Theoretically, views of the taxpayers and tax collectors are that tax compliance means adhering
to the tax laws, which are different from one country to another. The goal of tax administration is
to foster voluntary tax compliance (Silvani, 1992) and hence reduce tax gap (difference between
taxes paid and owed for all taxes and all taxpayers) and “compliance gap.” Tax compliance,
according to Cobham (2005), is a problem to many countries as measured by tax to GDP ratio
although it has been improving for many countries. It remains a big challenge to low income
countries..According to Ajzen’s (1991) Theory of Planned Behavior, attitude relates to one’s
own personal views about a behavior. Attitude may also be defined as positive or negative views
of an “attitude object”; i.e. a person, behavior or event. In relation to taxation, taxpayers’
attitudes may be defined as positive or negative views of tax compliance behavior.

Chapter Three

Methodology

3.1 Methods of Data Collection

In order to achieve the objective of the paper the researcher will use both primary and secondary
data. Primary data will be considered as highly relevant because it will helps the researcher to
emphasize on the respond of direct participants of the sectors. It will be obtained through open
and closed ended questioners and informal interview for both informal and formal business

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traders. Secondary data will be collected through referring the annual compliance report of
ERCA and related literature will collected from previous studies which will helps the researcher
as supplementary data.

3.2 Sampling Procedure

The researcher will use stratified and simple random sampling methods to select the respondents.
Stratified sampling method will be used to categorize the population in to strata (informal and
formal traders). And simple random sampling method will be applied to select respondents from
the strata.

3.3 Data collection Sample

The target for this research will be informal traders and formal sector trader’s noncompliant with
existing tax system due to the informal sector expansion. So as to gather reliable data the
researcher will take sample of 50 traders from informal sector and 50 from formal traders will be
taken randomly from Addis Ababa; merkato, piazza, Mexico and shiromeda for open and closed
ended questioner and informal interview.

3.4 Data Analysis Methods

The researcher will apply both descriptive and statistical method to analyze the collected data;
Statistical method will be used to analyze primary data which will be obtained through
questioner and descriptive method will be used by the researcher to analyze data gathered from
secondary sources, open ended questioner and interview which are important to draw
conclusions and interpretation.

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 4. Work plan and Budget

The research will be conducted based on work schedule stated below

4.1 Time Allocate For Each Activity

No. Activities February March April May June July

2017
1 Introduction

2 Literature
review
3 Questionnaire
development
4 Preliminary test
of
questionnaire
5 Improving
questionnaire
6 Data collection,
Coding and
organizing
7 Data analysis
And
interpretation
8 Thesis write up

9 Submission of
the report

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 4.2 Budget Breakdown

The necessary budget for the purpose of the research will be under taken is stated below

No Items Measure Quantity Price per Total

. unit/day cost/price
1 Supply and Mobil card Birr 25 25 625
equipment
Photo copy Pages 300 0.5 150
Printing Pages 200 1 200
Binding - 1 20 30
Sub-total 1,005.00
2 Stationary Photo copy pack 3 125 375
paper
pen packet 2 - 144
Pencil Packet 1 - 70
Staples Packet 3 30 20
Flash disk - 2 120 240
Re-writable - 3 20 60
CD disk
Note book - 4 50 200
Marker - 1 200 200
Sub-total 1,309.00
3 Transport 1000
4 Internet 1000
5 Contingent 2000
Grand total 6,314.00

 The total amount of money for undertaking the study will be 6,314.00 ETB

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References

1. CSA (2004) Report on Urban Informal Sector Sample Survey, Addis Ababa, Ethiopia
2. MoFED (2010) Growth and Transformation Plan (GTP) 2010/11-2014/15, Ministry of
Finance and Economic Development (MoFED), September 2010, Addis Ababa
3. Addis Ababa City Administration, Micro and Small Enterprises Development Strategy,
Addis Ababa, July 2000.
4. Asmamaw, E. (2004). Some controversies on informal sector operation in Ethiopia: problems
and prospects for development strategies.
5. Ageba G. and W. Amha (2003), Policy impact and regulatory challenges of the micro and
small scale enterprises (MSE) in Ethiopia, Addis Ababa: Ethiopian Development
Research Institute.
6. CSA (2005), Labor Market Survey, Federal Democratic Republic of Ethiopia. Addis
Ababa: Central Statistical Authority
7. Chu, M.D. (2001), Problems encountered by informal traders in open markets: the case of
mercato, Addis Ababa: ECSC
8. YitbarekTsige, 2001, Micro and Small Enterprises in Addis Ababa and Related Agenda
Framework for Development, (Amharic Paper), Addis Ababa
9. World Bank Group (2007), Concept of Informal Sector, n.d, working paper

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