The Unofficial Economy and Economic Development

In developing countries, informal firms (those that are not registered with the government) account for about half of all economic activity. We consider three broad views of the role of such firms in economic development. According to the romantic view, these firms would become the engine of economic growth if not stopped by government regulation. According to the parasite view, informal firms, by avoiding taxes and regulations, unfairly compete with the more efficient formal firms and, by taking away their market share, undermine economic progress. According to the dual view, informal firms are highly inefficient, do not pose much threat to the formal firms, but also do not contribute to economic growth, which is driven by the efficient formal firms.

Using data from World Bank firm level surveys, we find that informal firms are small and extremely unproductive, compared even to the small formal firms, and especially relative to the larger formal firms. Compared to the informal firms, formal ones are run by much better educated managers. As a consequence, they use more capital, have different customers, market their products, and use more external finance. Hardly any formal firms had ever operated informally. This evidence is inconsistent with the romantic and parasite views, but supports the dual view. In this "Walmart" theory of economic development, growth comes from the creation of the highly productive formal firms. Informal firms keep millions of people alive, but disappear over time.