Informality as handcuffs:  A commonly cited view is that of de Soto (1989), who argues that informal firms are potentially very productive, but are constrained by costly government regulations, bureaucracy and their inability to secure property rights and to access finance. A key assumption is that informal firms would be fundamentally similar to formal firms, were they not constrained by policy. The implication of this view is that – if the barriers to official status were lowered and capital provided – informal firms would formally register and then take advantage of the benefits of formalisation, which would then lead to their expansion and wider economic growth.

While this first theory could be labelled as the “optimistic view”, the other two prominent theories take a more sceptical view of informal firms, considering them as relatively unproductive. 

Informality as a rational choice:  Maloney (2004) argues that the firms that would benefit from formalising already do formalise, whereas smaller and less productive firms rationally opt out of the formal sector because they perceive little benefit to being formal. Since such firms are constrained by their lower levels of human capital, being in the informal sector is often the optimal decision given their preferences. A related view has been referred to by some as the “parasite view”. This view holds that, while they are informal as a result of a rational decision, informal firms gain a substantial cost advantage over formal firms by avoiding taxes and regulations. They remain small to avoid detection (Ulyssea, 2018). These firms hinder the growth of the economy because their small scale makes them unproductive, but at the same time their cost advantages allow them to take away market share from bigger, more productive, formal firms. The implication of this view is that governments should aim to decrease the number of informal firms by reducing tax evasion and enforcing regulations.

Informality as a stage of development: A related view is the “survival view”, which argues that informality is a survival strategy for low-skilled individuals in economies that do not generate enough opportunities for wage employment. These individuals would prefer wage employment but are screened out as a result of their lower productivity, and so are unable to find formal jobs (Fields, 2004). The implication is again that it is not privately optimal for the survival enterprises they create to formalise, so policymakers should only attempt to bring them into the formal sector if there is a compelling public rationale for doing so.

In the upcoming sections, we discuss the empirical evidence from a number of interventions, with the findings shedding light on the relevance of these three views of formalisation.

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