Casting a shadow: Productivity of formal firms and informality

Informality is a salient feature of most developing economies. Two important concerns arise from informality. First, informal firms tend to be less productive than formal firms. Second, the competition from informal firms can weigh on the productivity of firms in the formal sector. These challenges can lower the aggregate productivity and thereby retard overall development in countries where the informal sector is pervasive. Our analysis provides robust evidence on both issues using firm‐level survey data for a large cross section of countries. We also examine the extent to which firm characteristics and business environment quality shape the productivity gap between formal and informal firms as well as the impact of informal competition on the productivity of formal sector firms. The results show that, on average, the labor productivity of informal firms is about one‐fourth that of formal firms. Moreover, competition from informal firms lowers the labor productivity of formal firms by 20%–24%. In line with the “parasite” view of informality, the negative impact of informal competition on the productivity of the formal sector firms is more pronounced when the business environment is less conducive to operating formally due to high corruption, burdensome regulations, and weak institutions.