Many firms in developing countries are informal, that is they operate without registering with the government. For example, in a labor market survey of Mexico, nearly 50 percent of business owners report that their firm is not registered with the authorities.
Different explanations have been put forth to explain why firms operate informally. One view, associated with De Soto (1989), is that informal business owners are viable entrepreneurs who are being held back from registering their firm due to complex regulations. Another view, expressed for example by Tokman (1992), sees informal business owners as individuals who are trying to make a living while they search for a wage job.
I used to be partial to the De Soto view. However, a few years ago, I wrote a paper on the impact of a business registration reform in Mexico (Bruhn, 2008), expecting that I would find that the reform led informal business owners to register their business. Surprisingly, this is not what I found. The reform had positive effects, creating more registered businesses and employment, but these businesses came from wage earners setting up new businesses, and not from informal business owners registering.
Ever since, this finding has bothered me. Over the following years, new research emerged arguing that informal business owners are heterogeneous and that both the De Soto and Tokman views may be correct, depending on which groups of entrepreneurs are under consideration. In particular, De Mel, McKenzie, and Woodruff (2010) find that 70 percent of self-employed microenterprise owners in Sri Lanka have personal characteristics similar to wage workers, while the other 30 percent have characteristics similar to owners of larger firms. These 30 percent are the ones who might be held back by regulation (as argued by De Soto), while the other 70 percent may be looking for a job (as argued by Tokman). In order to make this classification, De Mel, McKenzie, and Woodruff use discriminant analysis, a tool usually used by biologists to separate animals or plants into species on the basis of easily measured characteristics.
This paper gave me the idea of applying discriminant analysis to the sample of informal business owners I studied in my research on the registration reform in Mexico to help me isolate the business owners that would be most likely to register after the reform. In practice, this works as follows. I first take only individuals who are either wage earners or formal business owners and compare their background characteristics, such as gender, age, marital status, and education. Based on this comparison, I compute a set of weights on the characteristics that allows me to predict whether a person is a wage earner or formal business owner. I then take these weights and apply them to the same background characteristics in the sample of informal business owners. This allows me to separate informal business owners into the ones who are similar to wage earners and those who are like formal business owners. The results of this analysis are summarized in a new working paper (Bruhn, 2012) and show that about 50 percent of informal business owners in my sample from Mexico fall into each group.
I then examine the effect of the business registration reform on the registration decisions of these two separate groups of informal business owners. It was a relief to me when I found that informal business owners who have characteristics like formal business owner were indeed more likely to register after the reform, consistent with my original expectations about the impact of reform. In contrast, business owners who have characteristics like wage earners became less likely to register after the reform . This explains why my earlier paper did not find an effect on registrations when looking at all informal business owners. The next question then is why are informal business owners with characteristics like wage earners less likely to register after the reform? The answer is that they are more likely to become wage earners instead. My previous paper showed that the reform increased employment, which apparently helped these informal business owners find a job. So, overall, the reform seems to have led to a more efficient allocation of individuals into occupations, providing additional evidence of the benefits of business entry reforms. On top of that, the findings also confirm the argument that informal business owners are a mix of De Soto and Tokman types.
Bruhn, Miriam. 2008. "License to Sell: The Effect of Business Registration Reform on Entrepreneurial Activity in Mexico." World Bank Policy Research Working Paper No. 4538.
Bruhn, Miriam. 2012. "A Tale of Two Species: Revisiting the Effect of Registration Reform on Informal Business Owners in Mexico." World Bank Policy Research Working Paper No. 5971.
De Mel, Suresh, David McKenzie, and Christopher Woodruff. 2010. “Who Are the Microenterprise Owners? Evidence from Sri Lanka on Tokman v. de Soto.” in International Differences in Entrepreneurship, J. Lerner and A. Schoar (eds.), pp.63-87.
De Soto, Hernando. 1989. The Other Path: The Invisible Revolution in the Third World, New York, NY: Harper & Row.
Tokman, Victor. 1992. Beyond Regulation: The Informal Sector in Latin America. Bolder: Lynne Rienner Publishers.