Does competition from informal firms hurt job creation by formal manufacturing SMEs in developing and emerging countries? Evidence using firm-level survey data

The entrepreneurial perspective and “legalist” view of informality suggests that many informal firms can compete with formal firms, and often “unfairly” so because informal firms do not pay taxes or comply with costly regulations that formal firms must shoulder. Thus, informal firms can negatively impact the performance of formal sector firms in critical areas such as jobs creation. A rigorous empirical analysis of such impact, however, is limited, and almost non-existent for jobs creation. This paper contributes to the literature by estimating the impact of competition from informal firms on the growth rate of employment of formal manufacturing SMEs in 109 developing and emerging economies. Methodologically, the paper contributes by drawing on several theoretical predictions of the entrepreneurial perspective and “legalist” view of informality as a defense against endogeneity concerns. The results show that the growth rate of employment among formal sector manufacturing SMEs declines by 1 percentage point for each one standard deviation increase in informal competition. This adverse effect is bigger in countries where the business environment is less favorable to operating in the formal vs. the informal sector. Our findings have important policy implications given the shortage of high-paying formal sector jobs in most developing countries. Our results indicate that informal sector is less effective in alleviating jobs scarcity than previously thought; informality may reduce the availability of high-productivity formal manufacturing jobs; policies supporting informal sector must distinguish between informal firms that compete more vigorously against formal firms from the rest to minimize the harmful effect of informality on jobs growth in the formal sector; and a better business environment is important for ensuring greater harmony between formal SMEs and informal firms in the manufacturing sector.