Formal Business

Is the informal sector a pill of poison for economic development or is a byproduct of stagnation and poverty? Academics believe that the former usually want to argue that entrepreneurs in the informal sector are a great untapped resource that can be released to stimulate growth, or that informality-through unfair competition, hinders growth in the formal sector. Others, as we reported, emphasizing instead that the slow growth requires poor and uneducated to the informal economy. Rafael La Porta, of Dartmouth University and Andrei Shleifer, Harvard University belong to the latter camp. In a recent article that summarizes much of the mounting body of research on informality and growth, and they claim that the informal economy seems to be an effect and not a cause.

Mr. La Porta and Shleifer get your paper comparing different measures of the informal economy and conclude that they are closely related. According to these measures, the informal sector becomes almost half of the economy in many developing countries. Rich countries have, on average, about 42 registered businesses per 1,000 people, while the corresponding figure is only three in poor countries.

Informal enterprises are typically very small. One study estimates that the average formal company employs 126 people while the typical informal company employs only four. In addition, informal firms have extremely low productivity, largely because they are usually run by poorly educated entrepreneurs. The bottleneck for economic growth in many poor countries, the authors calculate well, maybe not mostly a shortage of educated workers, but an under-supply of educated entrepreneurs.

Low productivity is the critical variable, I think authors. While it is true that tax evasion and regulations to encourage firms to remain informal, Messrs La Porta and Shleifer estimate that many informal businesses are simply too unproductive to survive in the formal economy. Hence they predict that reducing registration costs that do not generate a major change in the formal economy or sustain growth.

To support his argument referred to the survey results indicate that government bureaucracy does not seem to be a big problem for many businesses in the developing world. Business World Bank research, for example, show that in many countries, less than 10% of informal businesses worry about corruption, licensing, permits or the legal system. The authors also point to results that demonstrate that normally nine in ten businesses started as registered trademarks. This means that the transition from the informal sector into the formal economy is relatively rare. The informal sector shrinks usually following periods of strong economic growth.

Mr. La Porta and Shleifer argue that "informal economies are so large in poor countries because their managers are so unproductive." They warn that tax or regulate informal businesses in an attempt to bring them into the formal economy can take them out of business, causing even greater poverty and underdevelopment. It therefore seems as if the policies to encourage the formalization are well intentioned, the best recipe for reducing the informal sector is economic growth.

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