Informality
•  What is informality?
–  Activity “unregulated by the institutions of society, in a
legal and social environment in which similar activities
are regulated.” (Castells and Portes, 1989)
–  “…the people’s spontaneous and creative response to
the state’s incapacity to satisfy the basic needs of the
impoverished masses.” (Vargas Llosa, forward to The
Other Path)
–  Companies “…avoiding taxes and regulations more
than [offsetting] their low productivity and
scale.” (Farrell 2004)
Informality
•  Where does informality come from? Three
perspectives:
–  “Hiding” or exit: producers want to avoid taxes and
regulations, and escape (McKinsey)
–  “Exclusion” High costs of compliance (de Soto; Doing
Business)
–  Dual economy / stages of development (Lucas,
Lagakos)
Informality and state capacity
•  All three may both be based on cost-benefit
calculations by firms. But differences:
–  Hiding: State is weak. Weak public goods to pull people into the
formal sector; weak enforcement capacity to push people into
the formal sector
–  Exclusion: State is oppressive, with regulations that prevent
firms from complying.
–  Dual economy / stages of development: Could be a mixture of
the two. Either not enough formal jobs created by formal sector,
or other infrastructure / inputs not provided.
Informality: Self Employment
Source: Golin 2002
Exclusion: Doing Business
•  The World Bank has spearheaded a major
effort in the past decade to lower costs of
entry. From 2010 Doing Business report:
Source: Doing
Business website
Doing Business
•  75% of countries have reduced the burden
of starting a business since 2004:
Source: Doing
Business website
Analytical framework
•  Who will be affected by a reduction in the costs
of formality? May be effects on two margins:
–  Formalization of existing formal firms
–  Startup of new firms.
•  Think first about those shifting from informal to
formal. Assume rational weighing of costs and
benefits of formality. Something like this:
Formalizing the informal
•  Lowering the costs of registering clearly should
unambiguously increase formalization by
informal firms
•  Note that given positive costs of registration, it
must be the case that π f > π i
–  This might be because public goods provided in
formal sector, or because of sanctions if caught being
informal
€
Effect on new entry?
•  A bit more complicated: Start by assuming that
each individual rationally weighs income from
self employment and income from wage work.
α β −α
That is, either earns wi or Yi = θ i k L
–  In other words, a wage or income from a production
function where output depends on entrepreneurial
ability θ.
•  We need to think €about the distribution of
entrepreneurial talent.
Effect on new entry?
•  Lucas (1978) develops a ‘span of control’ model.
Those with highest θ’s become entrepreneurs.
•  Work through this with graphs. Focus on three
variables:
–  Return to entrepreneurial ability in the formal sector
–  Return to entrepreneurial ability in the informal sector
–  Wage rate (endogenous to demand)
Entrepreneurship and wage work
θf(K,L)
Profit from running
a firm (formal sector)
Ff θ (Kf , Lf)-C
w*
θ
Wage workers
Form entrep
Adding an informal option
Finf θ (Kinf , Linf)
θf(K,L)
w*
Ff θ (Kf , Lf)-C
θ
Wage workers
Inf entrep
Form entrep
Adding an informal option
Finf θ (Kinf , Linf)
θf(K,L)
w*
Ff θ (Kf , Lf)-C
Note: Informal sector
firms are less productive,
but making them formal
does not make them more
θ productive.
Wage workers
Inf entrep
Form entrep
Effect of reducing cost of formality
Finf θ (Kinf , Linf)
θf(K,L)
Ff θ (Kf , Lf)
w*
Ff θ (Kf , Lf)-C
θ
Wage workers
Inf entrep
Form entrep
Effect of reducing cost of formality
Finf θ (Kinf , Linf)
θf(K,L)
Ff θ (Kf , Lf)
w*
Ff θ (Kf , Lf)-C
θ
Wage workers
Inf entrep
Form entrep
Effect of reducing cost of formality
•  Easy to see there will be shift from informal to
formal. Transition from wage workers – formal
employers is less clear. Would require a model
of types.
•  For example, distaste for operating informally, which varies
across individuals. Or, alternatively, two types of workers with
different wage schedules.
With two-tiered wage rates
Finf θ (Kinf , Linf)
θf(K,L)
Ff θ (Kf , Lf)
w*(2)
w*(1)
Ff θ (Kf , Lf)-C
ww(1)
ww(2)
θ
With two-tiered wage rates
Finf θ (Kinf , Linf)
θf(K,L)
Ff θ (Kf , Lf)
w*(2)
w*(1)
Ff θ (Kf , Lf)-C
ww(1)
ww(2)
θ
Empirical evidence on entry costs
•  What do we know about the effect of a reduction
in costs of formality on decisions by firms /
potential firms? Bertrand and Kramarz exploit a
change in entry regulation in retail sector in
France: the 1973 “Loi D’Orientation du
Commerce et de l’Artisanat”
–  “Since 1974…The creation or extension of any new
large retail establishment has first to be approved by
a regional zoning board composed of store owners,
consumer representatives, and region- ally elected
politicians”
Simple dif-in-dif
Bertrand and Kramarz
•  Regional boards made up up:
–  9 shopkeepers
–  2 consumer representatives
–  9 elected officials
•  Use two different approaches
–  Approval rates by department (Problem?)
–  Vote shares (right/left) in department over time
Approval and entry, OLS
Regressions include year and department fixed effects
Voting and approval (1st stage)
Approval and entry, IV
French retail entry
•  Many policy changes happen all at once in
the country
–  David talked about using encouragement
designs to create variation
–  Bertrand and Kramarz use differences in
implementation of the law across region /
time. Is this exogenous?
•  State level policy in the US—e.g., Card and
Krueger, Neumark and Wascher)
Mexico -- SARE
•  Kaplan, Piedra and Seira (2007) and Bruhn
(2007) both look at data from Mexico following
SARE (System for Rapid Opening of Firms);
They reach somewhat different conclusions:
•  New firms are informal-formal transitions (Kaplan et al) or de
novo startups (Bruhn)
•  Effect is modest and short-lived (Kaplan et al) or more
substantial (Bruhn)
•  Increases competition and leads to lower price levels
(Bruhn), or has no effect on price levels (Bruhn)
SARE
•  Program to reduce the time required to obtain a
municipal operating license from ~30 days to 2
days.
–  Is the municipal license the key?
•  Implemented in some municipalities, but not
others
–  Not randomized, though as Kaplan et al point out,
changes in registration costs are rarely randomized
•  Applies to some sectors, but not others
–  List varies by municipality: retail yes, chemical
manufacturing no
SARE
•  Will compare changes in new firm registrations
in SARE municipalities with new firm
registrations in comparison municipalities
•  The much more convincing comparison takes a
double difference: eligible sectors vs. ineligible
sectors in SARE vs. non-SARE municipalities
–  Data from IMSS – worker health benefits – all formal
workers
SARE
•  A lot of effort in the paper to show that choice of
implementing SARE was independent of past
trends in registration
–  Related to political party of mayor (PAN)
–  Related to where in the 3-year term the mayor is (2nd
year)
•  But …
Trends
Several things to note: 1) seasonality; 2) SARE municipalities are very large;
3) declining trend
Resulting regressions
Why the declining trend?
•  Downturn in US coinciding with start of
SARE program. Problem because:
–  Big municipalities entered first, have closer
connection to US
–  Ineligible industries (manufacturing) more
affected by US economy than eligible
industries (retail trade)
–  Suggests the double difference will be more
credible
Double difference trends?
Double difference trends?
Where do new firms come from?
•  Transition from informal or de novo
Suggest it is transition because:
–  Temporary effect
–  Reduction in exit hazard rate. (But more able
entrants?)
SARE and firm survival
Duration of SARE effect
A ‘placebo’ test
An alternative view on SARE
•  Bruhn uses data from a labor survey to
examine the effect of the same program
–  Can capture firms w/o employees, not
registered at IMSS
–  Can look at income of incumbent firms (fell by
3.5%)
–  Can see where workers move (from wage
work to entrepreneurs, from unemployed to
wage work)
–  But fewer municipalities, shorter time frame
An alternative approach
•  De Mel et al take an alternative approach:
increase benefit of formal registration
rather than decreasing cost.
•  Again, a single country (Sri Lanka). But
this time a randomized implementation
•  Start with a sample of informal firms (not
de novo start ups). So think about
comparing the blue and yellow lines on the
prior graphs
Summary of interventions
•  Provide set of informal firms in Sri Lanka with
information and, sometimes, monetary
incentives to complete the registration process
–  Use the exercise to estimate the demand for formality
–  Also understand characteristics of firms more willing
to register
Structure of intervention
•  Focus on the DS registration. Why?
–  Most closely associated with tax payments
–  BRC needed for formal bank loans, issuance of
official receipts.
•  Perceived costs of registering?
•  Taxes (46%) ; time consuming (37%); subject to
ETF/EPF (24%)
•  Perceived benefits?
•  Bank account (56%); none (23%)
•  Did not know cost of registering, tax laws
Treatments
•  Sorted into groups of 5 firms, matching on
location, industry, # employees, willingness
to register (61%), perceived benefits of
being formal
–  Treatment 1: Information on costs and benefits of
being registered (prepared with DS, C of C), plus
reimbursement of direct registration costs (modest)
–  Treatment 2: Information plus payment of 10,000 Rs
(~$85, or 1/3rd of median monthly reported profit)
–  Treatment 3: Information plus 20,000 Rs payment
–  Treatment 4: Information plus 40,000 Rs payment
•  Treatment 4a: 80,000 Rs.
TREATMENT EFFECTS
0.5
0.4
0.3
0.2
0.1
0
Information
10,000 Rs
20,000 Rs
-0.1
ITT
TOT
40,000 Rs
What margin do registration
costs affect?
•  Does formalizing existing informal firms lead
them to expand more quickly?
–  No need to remain small and hidden
–  Ability to issue receipts, bid on government contracts
–  Bank accounts and bank credit
•  Another (perhaps more important) effect is
inducing entry by high-ability entrepreneurs who
would remain wage workers w/ high entry costs
–  Uncertainty in success of the venture, combined with higher
start-up costs
–  Much more difficult to analyze, because in a tail of the distn