Firms under fire! How insecurity affects formal firms’ existence

This paper studies the effect of insecurity on formal firms’ existence. We develop a flexible theoretical framework in which insecurity, a latent production cost, affects firms’ market entry, exit, and formality decisions. In our empirical analysis, we combine an original dataset on Afghan firms with georeferenced data on military events that we use to proxy insecurity. In the state-building context of post-2003 Afghanistan, military events reflect not only violence but also state capacity expansion. For formal firms, this latter channel dominates. As a result, increased exposure to military events conveys on average a reduction in effective insecurity and positively impacts formal firm existence. Nonetheless, this effect is highly heterogeneous depending on actors, location, timing and firms’ characteristics. The Afghan conflict has the specificity of deeply involving foreign countries. Mobilizing this particular source of exogenous variation, we identify the causal effect of an insecurity reduction on formal firms’ existence. We show that an increase of 1% in the exposure to instrumented military events raises the formal activity probability by 3.8%.