South Asia’s Informal Firms: Outsiders, Evaders, or Avoiders?

the least profitable informal firms to either shed workers or shut down. Thus, if the two sectors compete, productivity growth in the formal sector will tend to shrink informality. In contrast, if the two sectors produce complementary goods, growth in the formal sector will tend to increase informality.

Access to capital, managerial skills, and technology is another lever for enabling substantive change. For example, a government program that effectively addresses informational barriers to the adoption of better business practices could boost the earnings of informal entrepreneurs. Such an intervention might also induce formalization by removing managerial constraints on firm size and increasing the natural size of informal firms. It could make formalization more attractive because bettermanaged firms may have more to gain from access to government contracts. The main challenge for policy makers is to diagnose underlying market or institutional failures correctly and devise programs that can address them in a cost-effective manner.

This chapter’s framework has emphasized the heterogeneity among firms in the informal sector and how that matters in policy design. For effective policy design, it would be useful to know how many informal firms are informal because they are trying to avoid or evade regulations and how many only happen to be in the informal sector because of other constraints to productivity growth and market access.

The share of outsider-, avoider-, and evader-type firms in the informal sector of South Asian countries is ultimately an empirical question. It hinges on the distribution of the hypothetical natural firm size, that is, the size distribution that would naturally emerge if business regulations and taxes applied uniformly to all firms regardless of size. This natural size distribution is not observed directly. Nevertheless, examining the actual size distribution of formal and informal firms can throw some light on this issue. Although better and more frequent data collection on informal activities would be useful in settling this empirical issue, a main conclusion from the available incomplete data is that the share of the outsiders (type D) is large in South Asia; thus, policies that deal with distortions and enforcement capacity, while still relevant, should not be the only policies pursued in the region.

South Asian firms are predominantly small. In Nepal, according to the official census of firms, 91 percent of all firms engaged in nonfarm activities employ only five or fewer persons (figure 1.3). This share is even higher in Bangladesh and India. In general, firms with more than 10 persons account for fewer than 5 percent of all nonfarm firms in these countries.