We define informal firms as those that are engaged in legitimate business activities but are not registered for the relevant operating licenses or with the tax department. The majority of businesses in most developing countries are informal, with rates of informality highest for the smallest firms, most commonly those with an owner working alone or hiring one or two paid workers. A key question for policymakers is what, if anything, they should do to address the large number of small-scale informal firms. Before assessing the evidence on policies that have attempted to increase the number of formal firms, we discuss three prominent theories that explain the existence of informal firms, and outline the potential benefits and costs of formalisation.

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