One of my b-school professors, Rafael La Porta, has just published a paper on third world economic activity. The authors ask: Will the informal sector drive third world economic growth? There are three main schools of thought in this field.
- The Romantic view. If you've read De Soto's book (The Mystery of Capital), you know this argument. Essentially, adherents contend that the informal sector is very productive, and are held back by regulation, lack of access to finance and lack of secure property rights.
- The Parasite view. The main proponent of this view is the McKinsey Global Institute. In essence, they claim that informal firms have to stay small to avoid detection, since they're illegal. Therefore, they will never gain sufficient scale to produce efficiently. However, they have a cost advantage that they can and do use to undercut official firms in prices. In short, informal firms hurt growth due to lack of scale and because they take away share from formal firms.
- The Dual view. This is the traditional development economics view. Adherents contend that productive entrepreneurs find it worth their time and effort to pay taxes and bear the burden of regulation, since being legal is more profitable to them. Informal firms, however, stay small because the payoff will not be large for them. Essentially, informal firms are so because they consist of low-quality assets managed by low-ability managers. These firms are not in direct competition with formal firms, and will die off as each sector develops economically.
Having laid out the essential points about each school, La Porta and Schleifer present comparative analyses of data collected on formal and informal firms. Their data covers a range of factors affecting both types of firms, from regulation to taxation to corruption. They also gather data on human capital at each type of firm, and look at productivity in each sector.
To find out more, the conference version of the paper is here.
