A structural analysis of firms’ transition from informality to formality in Nigeria

This paper argues that firms’ transition from informality to formality is important in Sub-Saharan Africa but was overlooked in the literature. It develops a structural dynamic model of heterogeneous firms, rationalizing the empirical relationship between transition from informality to formality and taxes, financial constraints, regulations and enforcement. When calibrated to Nigeria’s data, the results of the model show that different policies can significantly reduce informality through both the extensive margin (i.e the creation of new formal firms) and the intensive margin (i.e the formalization of incumbent informal firms) with a positive effect on aggregate production, TFP, and government revenue. In absence of financial constraints, the intensive margin becomes quantitatively insignificant, demonstrating the importance of financial constraints in firms’ decision to delay formalization and underscoring the relevance of transition in modeling informality.