Informal versus Formal: Microfirms' Productivity Gaps

Although evidence of a productivity gap between formal and informal firms is observed, this 'formality premium' is less explored for microfirms. The informality of microfirms is a central concern in low- and middle-income countries, and a crucial demand is noted for designing policies addressing this issue because they are the bulk of the economic tissue. We fill this void by estimating a productivity premium for the case of Colombia, considering two margins of informality: extensive, referring to business registration, and the intensive, which includes as well labor regulations. We use a unique longitudinal dataset from the Microenterprise Survey by the Colombian Statistics Department, which follows approximately 39,000 micro-establishments with up to 9 employees during 2012–2016. We utilize the transition into and out of formality to estimate the productivity premium (yearly sales per worker) between informal and formal firms, thereby exploring differences concerning initial productivity. We use a fixed-effects quantile regression to explore differential effects along the productivity distribution. We find evidence of a premium for both the extensive (20%) and intensive margins (6%), a gap that is decreasing along with the firm's productivity. The evidence of these premiums is related to two growth strategies of firms: an increase in capital investments for the extensive margin and an increase in human capital quality for the intensive margin. Further, we find the premium is notoriously wider for young firms (less than three years in the business) with a steeper gradient. We do not find systematic differences across sectors, gender of the owners, and motivation. These results are new evidence that supports the existence of a premium and the transition into and out of formality of microfirms in middleincome countries. Moreover, they suggest that microfirms' formalization and growth policies should be oriented toward promoting and enhancing formality's benefits.