Introduction

CHAPTER 2

Formal Sector Distortions, Entry Barriers, and the Informal Economy: A Quantitative Exploration

ROBERTO N. FATTAL JAEF

Introduction

The goal of this chapter is to revisit the role of formal-sector distortions in accounting for the size of informal production.

The predominant view in the literature is that reforms that reduce regulatory hurdles to formalization have little success. These conclusions have been found both at the empirical microlevel, in studies that evaluate the impact of government reforms (Bruhn and McKenzie 2014), as well as at the quantitative macrolevel, in studies that feed regulation based proxies of entry barriers in models of firm dynamics to assess their explanatory power in predicting informal production.

This chapter revisits this view, leveraging a new methodology (Fattal Jaef 2019) to identify allocative distortions and entry barriers. The main question that we ask is: Does this novel measure of distortions portray a different picture with respect to the role of entry and allocative frictions in explaining the rise of the informal sector? To answer this question, we build a two-sector model where the size of the informal sector is endogenous and responds to distortions in the formal sector. Feeding our novel measure of entry barriers and idiosyncratic distortions in the model, we find that these are able to account for more than one-half of the observed informal employment share in India and to generate total factor productivity (TFP) losses of 15 percent.

The idiosyncratic distortions and entry barriers that are fed into the model are comprehensive model-based measures of the myriad of policies and market frictions constraining firm behavior in a given economy. It is instructive, prior to delving into further details, to outline concrete examples of what those policies and frictions could be. Further examples are discussed in annex 2B. A prominent example of a policy that misallocates resources across firms is the size-dependent enforcement of taxation. Limited by weak tax capacity, governments in developing countries concentrate taxation on the largest firms, where the enforcement is facilitated by the visibility. Doing this creates a distortion. Firms are encouraged to remain small, to not engage in innovation and capital accumulation, or even to remain outside the formal sector. Another salient example of a size-dependent policy, which used to be prominent in India, is licensing. Licensing requirements explicitly limited firm size, creating an incentive to curb investment and innovation and discouraging formalization. On the entry barrier front, a natural example is given by registration costs imposed by the government for the establishment of new firms. According to the World Bank and the Organisation for Economic Co-operation and Development (OECD), these registration costs are notoriously higher in less developed economies, constituting a plausible explanation for the lack of competition and the proliferation of large informal sectors.1

The model is a two-sector extension of the endogenous firm dynamics model of Fattal Jaef (2019). Consumers exhibit constant elasticity of substitution (CES) preferences over baskets of formal and informal goods. Within each sector, there is free entry and exit of a continuum of heterogeneously productive firms. In the formal sector, firm growth is endogenous, as firms invest resources in innovation. Informal firm dynamics are exogenous, but they are calibrated to match properties of the size distribution of informal firms in India.

The mechanisms generating a large share of informal production in response to distortions are intricately related to general equilibrium responses of wages and the relative price of formal and informal goods. Consider first the case of entry barriers to the formal sector. Here, the mechanism is easier to appreciate. With barriers to entry, fewer firms enter the formal sector. A decline in the number of producers reduces competition and translates into a decrease in wages and an increase in the relative price of formal goods. Consumers, then, switch expenditure to informal goods, mediated by their elasticity of substitution. Combined with the reduction in wages, entry is redirected to the informal sector, thereby increasing the informal employment share.

Idiosyncratic distortions—namely, distortions in the business environment that misallocate resources from the more to the less productive firms in the economy2—also increase the informal employment share through similar general equilibrium channels, albeit with different implications for firm dynamics in the formal sector. These distortions, by disproportionately affecting high productivity entrepreneurs, discourage firms from investing in innovation and misallocate resources to less efficient producers. As a result, aggregate productivity in the formal sector falls, and hence the relative price of formal goods increases