Conclusion

barriers in accessing electricity explain a reasonable share of the total value of the entry barrier identified by the model, a substantial unexplained component remains. Some of the complementary components are explored in annex 2B. In panel b of figure 2.6, we compute the informal employment shares that would be generated by the model if we fed it with the regulation-based estimates of entry barriers. As can be readily seen, while the model’s mechanisms still respond strongly to the regulation-based component of barriers to entry, the majority of the dots fall well below the 45-degree line, dictating that the model can capture a substantially lower share of the observed degrees of informality. In the concrete example of India, the informal share generated by the regulationbased indicators is one-half as high as the one in the data. Still, the implication from the figure is that efforts aimed at simplifying entry and ensuring easier access to electricity can go a long way in reducing informality and fostering formal entry.

This chapter proposed a theory of informality combined with novel measures of formal sector distortions to account for the observed levels of informality in India and around the developing world. The model is disciplined by firm-level data on the informal sector’s firm-size distribution in India, and it is fed with distortions that are identified from the formal sector’s firm-level data alongside a theory-based inference strategy.

The model shows that distortions in the formal sector can account for threequarters of the observed informality in India and that they follow quite closely the distribution of informal shares in the rest of the countries in the sample. The mechanism underlying the rise of informality is that formal sector distortions, in the form of barriers to entry and size-dependent policies, increases the relative price of formal goods and triggers a substitution of production, employment, and expenditure toward informal ones. Quantitatively, the mechanisms in the model dictate that these distortions are capable of explaining why informality is so prevalent in the developing world.

In future research, we seek to provide further insights on the properties of informal firms that rationalize their microscale. The model now interprets the informal firms’ size distribution as indicative of a productivity distribution with low levels of productivity. Competing alternatives can be developed in which the real constraint on size does not stem from the lower productivity of informal firms but rather from their lack of access to capital. Exploring this hypothesis further, both empirically and quantitatively, is left for future work.