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Does competition from informal firms hurt job creation by formal manufacturing SMEs in developing and emerging countries? Evidence using firm-level survey data

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Abstract

The entrepreneurial perspective and “legalist” view of informality suggests that many informal firms can compete with formal firms, and often “unfairly” so because informal firms do not pay taxes or comply with costly regulations that formal firms must shoulder. Thus, informal firms can negatively impact the performance of formal sector firms in critical areas such as jobs creation. A rigorous empirical analysis of such impact, however, is limited, and almost non-existent for jobs creation. This paper contributes to the literature by estimating the impact of competition from informal firms on the growth rate of employment of formal manufacturing SMEs in 109 developing and emerging economies. Methodologically, the paper contributes by drawing on several theoretical predictions of the entrepreneurial perspective and “legalist” view of informality as a defense against endogeneity concerns. The results show that the growth rate of employment among formal sector manufacturing SMEs declines by 1 percentage point for each one standard deviation increase in informal competition. This adverse effect is bigger in countries where the business environment is less favorable to operating in the formal vs. the informal sector. Our findings have important policy implications given the shortage of high-paying formal sector jobs in most developing countries. Our results indicate that informal sector is less effective in alleviating jobs scarcity than previously thought; informality may reduce the availability of high-productivity formal manufacturing jobs; policies supporting informal sector must distinguish between informal firms that compete more vigorously against formal firms from the rest to minimize the harmful effect of informality on jobs growth in the formal sector; and a better business environment is important for ensuring greater harmony between formal SMEs and informal firms in the manufacturing sector.

Plain English Summary

Informal sector hurts the growth of good manufacturing jobs. The informal or unregistered sector is credited with providing jobs to millions of individuals around the globe. While the sector harbors some portion of opportunity-led entrepreneurs who are successful in terms of income, most jobs in the sector are low paying and have low productivity when compared to jobs in the formal or registered sector. The relatively high-paying and high-productivity jobs in the formal sector can be adversely affected by competition from informal sector. One reason for this is that informal firms do not pay taxes or comply with costly regulations that most formal firms must shoulder. This allows many non-complying informal firms to steal market share from the formal firms, undermining the latter’s growth. Using firm-level survey data for 109 developing and emerging countries, this paper finds that competition from informal firms indeed reduces the growth rate of employment among formal manufacturing SMEs. As expected, this adverse effect is much larger when the cost of operating in the formal vs. informal sector is higher and the benefits lower. The finding has several important implications for policies on jobs availability, formalization of the informal sector, and overall development. For one, a better business environment is important for achieving greater harmony between informal firms and formal SMEs in the manufacturing sector.

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Data availability

The main data used is firm-level survey data collected by the World Bank’s Enterprise Surveys. These data are available at www.enterprisesurveys.org. Other data sources used such as World Development Indicators, World Bank, etc. are in the public domain.

Code availability

Stata do file for the regression results included in the paper are available on request from the author.

Notes

  1. One exception is Williams and Kosta, (2020) who use ES data to estimate the impact of informal competition on employment growth rate of formal firms. However, this study focuses on a single country, Bosnia and Herzegovina, compared to 109 countries in our sample. Our study differs from Williams and Kosta study in terms of the informality measure used, the endogeneity checks employed, and the results.

  2. Another important issue in the literature on informality that we do not cover since it is only tangentially related to our work is the transition of informal firms to formal firms. See for example, Pisani, (2019b).

  3. Details of the sampling methodology are included in a Note available here:

    https://www.enterprisesurveys.org/content/dam/enterprisesurveys/documents/methodology/Sampling_Note.pdf

    Other related information along with the firm-level data used is available at www.enterprisesurveys.org.

  4. Our main result of a large, negative, and statistically significant relationship between informal competition and firm employment growth rate holds whether we use the cut-off of 100 or 20 workers to define SMEs.

  5. Our main results are qualitatively unchanged if we restrict the sample to a shorter interval of 2010–2016 that includes 97 out of 109 countries in our full sample.

  6. In one robustness check (Section 5.3), we exploit variation at the sub-national or city times industry level. For these results, we tighten the clustering which is at the city times industry level.

  7. For some countries, information on the growth rate is available over the last 2 years instead of 3 years.

  8. To avoid too many missing data, average values over three years prior to the year covered by the ES are used.

  9. For Freedom From Regulation, Control of Corruption, and the Rule of Law variables, we use their 2 years lagged values.

  10. Our results are unaffected if we use alternative cut-off levels around the median instead of the median cut-off.

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Acknowledgements

I thank the Enterprise Analysis Unit of the Development Economics Global Indicators Department of the World Bank Group for making the data available. I would like to thank Jorge Luis Rodriguez Meza, Norman Loayza, and participants at a seminar organized by DECIG, World Bank for providing useful comments. All remaining errors are my own.

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    Mohammad Amin

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Amin, M. Does competition from informal firms hurt job creation by formal manufacturing SMEs in developing and emerging countries? Evidence using firm-level survey data. Small Bus Econ 60, 1659–1681 (2023). https://doi.org/10.1007/s11187-022-00672-z

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