2.3 Idiosyncratic Distortions and Entry Barriers

FIGURE 2.3 Idiosyncratic Distortions and Entry Barriers

Source: Fattal-Jaef 2022. Note: TauE = entry tax or barrier in the undistorted economy in the model. TFPQ = quantity total factor productivity. TFPr = revenue total factor productivity.

evidence of allocative or entry distortions in the most developed countries. India, however, exhibits a very high level of both productivity-dependent idiosyncratic distortions and barriers to firm entry. The question we ask in this chapter is: to what extent can this combination of distortions account for the observed levels of informality in India?

PRODUCTIVITY DIFFERENCES BETWEEN FORMAL AND INFORMAL FIRMS: THE ROLE OF CAPITAL

Prior to delving into the quantitative analysis, it is useful to address a particular concern with respect to our approach for modeling the informal sector. Our inference from the differences between the firm-size distribution of formal and informal producers in India are indicative of large productivity differences between formal and informal firms. However, it may be argued that the smaller size of informal firms may not conform to underlying productivity differences but rather to barriers in the access to physical capital. It is plausible in theory that an informal firm is as productive as a formal one but remains small because the informal status precludes the access to capital. The ultimate answer to this conjecture is empirical and would be provided by a measurement of the TFP distribution among informal firms. To my knowledge, this cannot be done.

However, one can construct a series of equally reasonable arguments that would help rule out, or at least tone down, the access to capital story. The first argument is that, if informal firms were indeed more productive, they would manage to grow out of the borrowing constraints through internal savings and eventually access the needed capital. Empirically, then, we would observe somewhat of a steep growth of informal firms’ size over the life cycle. The evidence on this subject from Mexico (Busso, Levy, and Torres-Coronado 2019) and Brazil (Ulyssea), however, is quite the opposite: life-cycle growth is flat among informal producers. The second argument is that if informality were indeed precluding productive firms from accessing capital, reforms that alleviate registration and formalization costs would trigger a burst of formalization and firmgrowth thereafter. Once again, the quasi-experimental evidence in various contexts (see Bruhn and McKenzie 2014; Ulyssea 2020) is not supportive of this prediction: formalization is virtually zero in response to changes in the regulatory environment.

In short, the hypothesis that the biggest constraint to the size of informal firms is not lower productivity but rather poorer access to capital is a very reasonable one that cannot be entirely ruled out or validated until estimates of informal firms’ TFP are available. However, indirect arguments based on implied behavior that would have to be observed if that were to be the case do not support the argument; therefore, this chapter loads all the differences in size on differences in productivity.

QUANTIFYING INFORMALITY

Our goal now is to address the main quantitative question of the chapter: how much of the observed informal production in India can be accounted for by formal sector distortions? These are not simply proxies of a particular distorting policy or the outcome of a specific policy reform, which were the object of study in the earlier literature. The distortions we are considering are comprehensive measures that are inferred based on the observed behavior of firms in India; accordingly, they have the potential to exert a more notable effect than those policy interventions or regulations that are based on indicators studied earlier in the literature.

Our quantitative exploration is conducted in the following steps. First, we calibrate structural parameters in the model—such as those governing the elasticities of substitution, the entry costs, and the innovation cost function—to match salient firm-level properties of the US. In particular, we require the relative entry costs, fe1 and fe2, and the relative sector-wide productivity levels A1 and A2 to be consistent with an informal employment share of 8 percent in the US. The innovation cost function in the formal sector is parameterized to replicate the life-cycle growth and the employment share in the top 10 largest firms in the US manufacturing sector. The growth and exit rate in the informal sector, in turn, are set so as to replicate the pattern of the informal sector’s firm-size distribution in India. Parameter values associated with this calibration strategy are reported in annex 2A.

The second step is to introduce the estimate of the productivity elasticity of distortions and the entry barrier in India into the model, and solve for the associated stationary equilibrium. Figure 2.4 presents the results from this exercise. Panel a reproduces the informal