Going Underground: The impact of deterrence on the landlords' decision to operate informally

This paper examines how enforcement of regulations affects firms’ decision to operate formally, underground, or exit the market. The firms in our study are landlords of rental properties. Using a unique data set that identifies underground and exited properties, we find that enforcement makes going underground more likely when only fines are issued but less likely when enforcement requires abatement. Additionally, observing higher levels of enforcement among neighbouring properties (general deterrence) increases the likelihood of going underground when abatement is required. These findings are consistent with the predictions of a theoretical framework we develop. Accordingly, the study makes two contributions to the informality literature. First, that whether enforcement has a positive or negative impact on operating underground depends on whether that enforcement requires abatement. Second, it identifies both the extensive margin between informality and formality, and the margin between informality and exiting an industry.