Does Competition from Informal Firms Impact R&D by Formal SMEs ? Evidence Using Firm-Level Survey Data

The informal sector is an important source of livelihoods and jobs for a vast majority of peoplein developing countries. However, there is concern that it may undermine growth and development of the formal sector.For instance, the growth literature indicates that research and development activity and innovation are a key driver oflong-term growth. How does the competition that formal sector firms face from informal sector firms affect researchand development activity by the formal firms The present paper attempts to answer this question using firm-levelsurvey data for small and medium-size enterprises in a large cross-section of mostly developing countries. The resultsshow that higher informal competition leads to greater a likelihood of spending on research and development by formalfirms. For the most conservative baseline specification, a one standard deviation increase in informal competitionleads to an increase of 5.2 percentage points in the likelihood of spending on research and development by formalfirms. This is a large increase given that less than 18 percent of the firms in the sample engage in research anddevelopment activity. Further, consistent with the “parasite” view of informality, the positive impact ofinformal competition on research and development activity is magnified when the business environment is less conducive tooperating in the formal sector compared with informal sector due to factors such as higher corruption, weaker rule oflaw, more burdensome business regulations, and a higher tax rate on profits. As expected, there is no impact of informalcompetition on research and development activity among large firms. The main findings are robust to several controls,alternative specifications, and endogeneity checks.