When Will Formality Become the Norm?

This chapter considers informality to be a choice in relation to regulation by the state. In developing economies, the availability of information to an external agent about a firm’s economic activities is limited. Information from outside a business establishment about the scale of activities is available to fiscal authorities from the recorded transactions that are made through the formal financial system which is a good source of checking the information that the firm may provide. Taxation and its enforcement are thus enhanced to the extent that firms use the formal financial system. If informal finance and cash transactions are used, they become difficult to monitor and tax. Thus, there is a link between taxation, formal financial intermediation, and the decision of firms as to whether to operate formally that this chapter explores. Continuing to be informal is then a choice that is made when the productivity enhancement of the enterprise from accessing formal finance is insufficiently high, when the costs of operating in the informal sector are low, when indirect taxes are set at a high level, and if the fixed regulatory cost of setting up in the formal sector is high. We investigate what financial development in terms of a reduction in the cost of financial intermediation does to the decision regarding whether to operate formally or informally. We demonstrate some counterintuitive possibilities such as a decline in capital intensity by switching to becoming a formal enterprise since the increased productivity is offset by the fixed costs of setup and other relevant costs. We also refer to the role of collateral regimes, bankruptcy laws, and judicial efficiency in affecting the choice of whether to continue to be informal.