Our most basic finding is that high productivity comes from formal firms, and in particular large formal firms. Productivity jumps sharply if we compare small formal firms to informal firms, and rises rapidly with the size of 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 (see also Lewis 2004, Banerjee and Duflo 2005).
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.
Growth strategies, then, need to focus on formal firms, especially the larger ones. Surely reducing the costs of formality, such as the registration costs, are a good idea, but these seem to be a small part of the story. Likewise, some of the almost‐standard proposals for development, such as improving land rights, the legal environment, and even the human capital of the employees appear to be relatively minor factors, from the viewpoint of official entrepreneurs. The main obstacles to the operations of formal firms, according to our data, are four: 1) human capital of entrepreneurs, 2) taxation, 3) electricity, and 4) finance.
To us, the most striking finding is the sharply higher education of managers of official than unofficial firms, with no corresponding difference in the human capital of the employees. This might suggest that educational policies, particularly those emphasizing secondary education, might be conducive to the formation of entrepreneurial talent that can run formal firms. We do not mean to suggest that formal education is either a necessary or sufficient condition for entrepreneurial skills. But the data seem to be quite clear that some kinds of management (for example marketing or finance) require education. One can also think of other sources of human capital, such as immigration, as supplying the required entrepreneurial talent.
There is growing evidence that corporate income taxation deters investment and formal entrepreneurship. Using a new data set of corporate income taxes in a large number of countries, Djankov et al. (2008) find strong evidence that those taxes reduce investment, foreign direct investment, and entrepreneurial activity. Our evidence similarly shows that official firms perceive taxation as the top obstacle to doing business. To the extent that formation and growth of official firms are the principal engines of development, this perception must be taken seriously. Needless to say, one needs to also think about alternative sources of public finance, as well as the size of government, in the developing countries to figure out whether corporate income tax cuts are warranted. But the evidence points to a potentially serious problem.
The evidence suggests that official firms (just like the unofficial ones) perceive lack of access to finance to be a serious obstacle to doing business. Recent research has pointed to a broad range of legal and regulatory reforms that can underpin the development of financial markets, reforms that broadly seek to improve the legal rights of creditors and (in the case of very large firms) shareholders (see La Porta et al. 2008 for a survey). We should note, however, that although the evidence that connects good laws and regulation to financial development is quite compelling, the evidence that connects financial development to economic growth is not as strong. Having said this, unlike with tax cuts, there seem to be no compelling counterarguments to improving laws and institutions that underpin financial markets.
Finally, the evidence indicates that electricity supply, including disruptions, presents a problem for the unofficial as well as the smaller official firms. This compares to an interesting lack of concern with other limitations of infrastructure, such as transport, phone, or mail. Most large firms have their own generators, although smaller official firms, and the unofficial ones, do not and hence are more vulnerable.
The overall picture of economic development that emerges from this analysis is in some ways very similar to the traditional pre‐growth‐theory development economics, although it is related to the modern reformulations of economic growth through the lens of development economics (Banerjee and Dulfo 2005). The recipe for productivity growth is the formation of official firms, the larger and the more productive, the better. Such formation must perhaps be promoted through tax, human capital, infrastructure, and capital markets policies, very much along the lines of traditional dual economy theories. From the perspective of economic growth, we should not expect much from the unofficial economy, and its millions of entrepreneurs, except to hope that it disappears over time. This “Walmart” theory of economic development receives quite a bit of support from firm level data.
Thursday, 18 September 2008
In praise of larger and larger firms...
A new paper by La Porta and Shleifer sheds new light on the relationship between informality and economic development. It touches on many issues we have discussed here and reaches some very profound conclusions. Among them being that there appears little support for the romantic view of informal firms as drivers of economic growth or that increased “enforcement” leads to significant benefits to society. Rather the paper concludes that the best hope for economic development lies in the creation of large registered firms, run by ducated managers and utilizing modern practices, including modern technology, marketing, and finance. Key conclusions below: