Bringing Informal and Hard-to-Tax Sectors into the Formal Tax System

Why informal and HTT sectors remain outside the tax net

Estimates of the informal economy seek to measure how much economic activity is excluded from standard GDP figures, though this does not always align with what activity is taxed. The hard-to-tax, as the name suggests, are more directly defined by their absence from the effective tax base. In both cases, however, an important step is to more closely link measurement and policy.

There are several challenges to taxing the informal and HTT sectors.

First, these sectors are characterized by a proliferation of small firms operating primarily in cash. Economic transactions within these sectors, therefore, do not leave verifiable information trails that the government can use to identify and tax activity.

Second, tax compliance costs, such as registration and filing requirements, are high in many developing countries. These costs deter informal firms from voluntarily formalizing. Evidence from the World Bank and the International Labour Organization (ILO) shows that these costs disproportionately affect small businesses and rural populations.

Third, taxing small firms is often inefficient, as the cost of auditing typically outweighs the expected revenue gains. As a result, large-scale campaigns to bring informal firms into the formal sector may not be optimal, since newly registered firms are unlikely to contribute significant revenue. For instance, Pakistan’s experience from 2014 to 2021 showed that a tripling of registered taxpayers did not lead to a significant increase in revenue. Many newly registered entities paid little or no tax, highlighting the ineffectiveness of expanding the tax base without addressing compliance issues.

Fourth, governance weaknesses further exacerbate barriers to voluntary formalization. Taxpayer surveys routinely show a lack of trust in the revenue authority, with firms fearing harassment and corruption if they register.

Policy strategies to address informality and HTT sectors

A multi-faceted approach is needed to effectively tackle informality and HTT sectors. The following strategies, supported by research and evidence, highlight potential solutions:

1. Smart enforcement: By leveraging big data and machine learning, tax authorities can target enforcement efforts toward high-risk taxpayers both inside and outside the formal sector. For example, the UK’s HM Revenue and Customs (HMRC) uses its "Connect" system to cross-reference data from multiple sources, identifying potential tax evasion among both registered and unregistered firms.
2. Presumptive tax regimes: Simplified tax systems, where taxes are based on proxies such as turnover or land size, have proven effective in countries like Mexico and India. These regimes lower compliance costs while capturing revenue from small businesses and agricultural entities.
3. Technology-driven solutions: The adoption of digital payment systems and electronic invoicing can increase transparency and traceability. Brazil’s "Nota Fiscal Paulista" program, for example, promotes electronic receipts, reducing informal transactions and boosting tax compliance.
4. Differentiated approaches: Tailored tax policies for specific sectors, such as agriculture and the professions, are essential. For agriculture, land-based taxes or value-chain taxation can help indirectly capture income. For professionals, linking tax compliance to licensing requirements and using presumptive or withholding taxes can improve coverage.
5. Incentivizing formalization: Governments can reduce barriers to formalization by offering initial tax incentives, streamlining registration processes, and improving access to credit. Evidence from Uruguay shows that linking formalization to benefits such as crop insurance can encourage voluntary compliance.

Pakistan: Expanding the tax base without revenue gains

Between 2014 and 2021, Pakistan tripled its number of registered taxpayers through aggressive enforcement measures, including higher withholding taxes and restrictions on non-filers. However, tax revenue remained stagnant, with newly registered taxpayers contributing minimally. This highlights the need for balanced enforcement that prioritizes compliance within the registered sector over an uninformed expansion of the tax base.

Vietnam: Informality and progressive formalization

Vietnam’s 2009 tax reforms aimed to formalize businesses by simplifying tax procedures and linking compliance to benefits such as access to credit. Data from the ILO show a gradual decline in informal employment, particularly among women, indicating that tailored reforms and targeted policies can encourage formalization over time.

India: The GST and informality

The adoption of value-added tax (VAT) systems globally, including in most DMCs, has changed tax registration incentives, especially for small firms. India’s experience with its nationwide Goods and Services Tax (GST), a form of VAT, shows that small firms that would have otherwise remained informal are now incentivized to register due to the loss of input tax credits on purchases from unregistered entities. VAT systems thus capture at least a portion of revenue from informal activity at upstream stages. Moreover, they underscore the importance of maintaining a clean tax register, as inactive or delinquent registrants can erode revenue by facilitating fraudulent tax credit claims.

The challenges of taxing informal and HTT sectors require nuanced, evidence-based strategies that balance enforcement, incentives, and administrative capacity. While formalization efforts alone may not yield significant revenue gains, they can contribute to broader goals of economic development and equity. By leveraging smart enforcement, tailored tax regimes, and targeted incentives, governments in developing countries can gradually reduce informality and strengthen their fiscal capacity.

Asian Development Bank. 2025. Taxing Informal and Hard-to-Tax Sectors: A Policy Guide.