The informal sector and economic development

“Our most basic finding is that high productivity comes from formal firms, and in particular large formal firms. .... To the extent that productivity growth is central to economic development, the formation and growth of formal firms is necessary for economic growth.

Formal firms appear to be very different animals than informal firms, which accounts for their sharply superior productivity. Perhaps most importantly, they are run by much better educated managers. As a consequence, besides being larger, they tend to use more capital, have different customers, market their products, and use external finance to a greater extent than do the informal firms. There is no evidence that informal firms become formal as they grow. Rather, virtually none of the formal firms have ever been informal. It strains imagination, given the available evidence, that informal firms would sharply increase their productivity if only they registered.

Informal firms nonetheless play a crucial role in developing economies. They represent perhaps 30 or 40 percent of all activity. They provide livelihood to billions of poor people. Because these firms are so inefficient, taxing them or forcing them to comply with government regulations would likely put most of them out of business, with dire consequences for their employees and proprietors. If anything, strategies that keep these firms afloat and allow them to become more productive, such as microfinance, are probably desirable from the viewpoint of poverty alleviation. But these are not growth strategies in that turning unofficial firms into official ones is unlikely to generate substantial improvements in productivity.”

Rafael La Porta and Andrei Shleifer, "The Unofficial Economy and Economic Development", forthcoming in Brookings Papers on Economic Activity, Fall 2008 Conference (August 2008).

http://www.brookings.edu/economics/bpea/bpea_conferencepapers.aspx

http://www.brookings.edu/economics/bpea/bpea_conferencepapers_fall2008.aspx

Rafael La Porta is Nobel Foundation Professor of Finance at the Tuck School of Business at Dartmouth University and Andrei Shleifer is a professor in the Department of Economics at Harvard University. Dr. Shleifer was awarded the John Bates Clark Medal by the American Economic Association, awarded every two years to the most promising US economist under 40, for his seminal works on corporate finance, the economics of financial markets, and the economics of transition. He is cited as one of the 10 most influential economists in the world.

La Porta and Shleifer point to the benefits that formal organizations bring to the process of development in the form of their more extensive markets and wider division of labor, their higher capital intensity, and their generally more specialized approach to production, all of which yield higher productivity and incomes. What is surprising is that they find no evidence that informal firms become more formal as they grow and that none of the formal firms they studied had ever been informal.

While I do not doubt the underlying scholarship and the basic conclusions of their study as to the differences between formal and informal firms, I must say I wonder how relevant their conclusions are to the main point they try to make: That promoting informal firms is not a good strategy to promote growth. It may well be true that few informal firms become formal and a growth pole from which larger formal firms emerge. But it seems to me possible that the informal firms provide a training ground from which young businessmen and women gain the experience and knowledge needed to work in and grow formal firms. After all, one must ask the question, “Where do small formal firms come from if not from people with at least some minimal experience?” That minimal experience may well have been gained in the informal sector, so even if an informal firm doesn’t grow into a formal one, maybe it provides the training for later success.