Fading Away Informality by Development

Abstract

This paper focuses on the role of development on informality through higher wages and expanded production possibilities. First, it documents that richer countries have smaller informal, unregistered, plants in terms of employment on average, using informal plant-level survey data across countries. This negative relationship holds even after controlling for plant-level characteristics. Then, a dynamic-general equilibrium model with incomplete enforcement is developed such that formal and informal plants coexist in equilibrium. The model incorporates subsistence informality where agent with lowest ability levels run informal plants instead of being employed as workers. It also allows for agents with abilities between workers and formal managers to operate informally. In the model, when plants become more productive, some agents operating informally choose to be workers thanks to higher wages, and some transition into formality due to better production possibilities, which decreases informal mean size. The model parameters are calibrated to match the key properties of formal and informal plant-size distributions in Ghana. In the benchmark equilibrium, the subsistence informality accounts for the majority of informal plants. Quantitative results indicate that around 30% increase in aggregate output due to higher productivity is associated with roughly a one-quarter decline in the mean of informal plants.

Keywords: Informality, Economic Development, Plant Size, Productivity