Informality and Productivity: The Sources of Productivity Differentials between Formal and Informal Firms
Erol Taymaz.
Abstract
The informal sector constitutes a large share of employment and output in all developing countries. Although the informal sector is regarded by many researchers and policy makers as a source of employment developing countries desperately need, there is ample evidence that documents that informal firms are less productive, employ unskilled labor, and pay lower wages. This study analyzes the sources of productivity difference between informal and formal firms in Turkey. We estimate and compare productivity levels of informal and formal firms by taking into account the endogeneity of the choice between formal and informal operation. Our findings indicate that there is a significant productivity gap between informal and formal firms. More educated and experienced entrepreneurs move to the formal sector, and this process of self-selection contributes to widen the productivity gap between informal and formal firms. Life-cycle and learning theories are also supported by our findings. Even after controlling for all these factors (self-selection, differences in endowments, and learning), the productivity gap does not disappear. The findings suggest that there is a substantial untapped potential to increase productivity through formality. However, a large number of informal firms would not survive if they are forced to operate formally.
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