B2.1.2 The Importance of Informality in Services Relative to Manufacturing Is Most Pronounced When Comparing Shares of Employment and Value Added

BOX 2.1 Informality in the Services Sector (continued) FIGURE B2.1.2 The Importance of Informality in Services Relative to Manufacturing Is Most Pronounced When Comparing Shares of Employment and Value Added

Shares of value added and employment from unregistered businesses in Ghana, by sector, 2013

Share (%) 100 90 80 70 60 50 40 30 20 10 0 ManufacturingOther servicesHotels and restaurants Retail WholesaleProfessional/technicalTransportation ICT Administrative and supportFinancial and insurance % value added % employment % firms

Source: Calculations using the 2013 Integrated Business Establishment Survey of the Ghana Statistical Service. Note: The dataset includes only informal firms. Informality is determined by whether firms are registered at the Registrar General’s Department. No minimum size threshold has been applied. ICT = information and communication technology.

• One view—commonly associated with De Soto (2000)—emphasizes the role of burdensome regulations in keeping firms informal and unproductive and asserts that removing barriers to formalization would encourage firm growth. • A less favorable view of informality—as expressed by Farrell (2004) and Levy (2008)—emphasizes the benefits to informal firms of unfair competition and tax avoidance. • A third view—as expressed by La Porta and Shleifer (2014)—contends that informality is a symptom of lacking capabilities and that informal and formal enterprises have very different characteristics.

Generally, the informal sector underperforms the formal sector in terms of revenue, profits, employment, and productivity (La Porta and Shleifer 2014), and many informal entrepreneurs likely operate their businesses out of necessity rather than opportunity (Acs 2006). In Sri Lanka, roughly two-thirds of informal entrepreneurs have characteristics more akin to wage workers than to formal entrepreneurs (De Mel, McKenzie, and Woodruff 2010). In Mozambique, 62.7 percent of informal entrepreneurs would prefer to have a wage job that provides a similar income (Aga et al. 2021).

These findings do not necessarily imply that informality is undesirable. From a social protection point of view, the informal sector is important in providing economic livelihoods to many who cannot find employment in the formal sector. Gulyani and Talukdar (2010) study informal enterprises in the slums of Nairobi and argue that—when factors explaining selection into entrepreneurship are controlled for—poverty is lower among

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BOX 2.1 Informality in the Services Sector (continued)

households with a microenterprise than those without. Operating in the informal sector can also have a few benefits over working in the formal sector, such as increased flexibility, control over hours, and independence (Perry and Maloney 2007, 66).

Another reason for some optimism is that informal firms exhibit considerable heterogeneity, and evidence suggests that certain informal firms could operate successfully in the formal sector—in line with either the “De Soto view” or the more pessimistic “parasite view” of Farrell (2004) and Levy (2008). The estimated share of such firms varies. Ulyssea (2018) estimates that, in Brazil, roughly half of informal firms could thrive in the formal sector, with roughly one out of five of these firms facing formalization costs that are prohibitive (in line with the “De Soto view”). In Mozambique, 7.6 percent of informal firms have characteristics and productivity levels similar to formal firms (Aga et al. 2021). In Sri Lanka, although most firms did not benefit from a formalization program, a small group of participants (5 percent) significantly increased their performance following registration (De Mel, McKenzie, and Woodruff 2010).

with formal micro firms and could have potential to grow—as examined by Ulyssea (2018) for Brazil and by Aga et al. (2021) for Mozambique—this potential tends to apply to only a small group of firms. Unfortunately, as highlighted in this book’s “Spotlight,” sources of comprehensive firm-level data on informal enterprises remain scarce.

Findings Specific to Formal Firms When the analysis is restricted to formal firms, for which more data are available, the pattern of services firms being smaller than manufacturing persists and is visible across the services subsector groups identified in chapter 1 (figure 2.6). In both LMICs and HICs, the subsectors with the smallest average firm size are retail, vehicles trade, real estate, and professional services, all of which tend to be about four to five times smaller than a manufacturing firm in the same country. The sectors with the largest average firm size are transportation and storage; administrative and support services; and (in HICs) financial services.

These data, restricted to formal firms, show that in many sectors there are few differences between LMICs and HICs in average firm size. This is line with analysis from Latin America by Alfaro and Eslava (2020), who show that when including informal firms, small firms play a much larger role in LMICs than HICs, but when excluding these firms, the size gap between LMICs and HICs narrows. These narrowing gaps—at times, disappearing gaps—in firm size highlight the importance of informality in explaining firm-size differences between countries. Nevertheless, some subsectors continue to see a size gap between LMICs and HICs, most notably in the low-skill domestic services of retail and “other services” (including social, community, and personal services).