Informal firms, investment incentives and formalization

In a typical developing country, the majority of small firms are informal and entry costs into formality are high. This paper is motivated by these two observations. It asks the question of what can be expected in terms of firm investment, growth and formalization in such a setting. It also studies the effects of policies towards the informal sector on formalization decisions. I show that the investment paths and growth trajectories differ substantially between firms that choose to formalize and those (ex-ante almost identical firms) that do not. Second, the formalization decision depends non-trivially on the productivity of the informal firm, due to the balancing of an accumulation effect and a threshold effect. This, in turn, has an effect on how policies towards the informal sector should be designed. Third, when aggregating over firms and a range of larger firms, but also a “missing middle”, much in line with actual firm size distributions observed in developing countries. Fourth, the long-run form-size distribution turns out to depend on the initial firm-level stock of capital, a result that can be interpreted as a poverty/informality trap.