Do marginal firms in Bolivia benefit from formalizing?

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David McKenzie and Yaye Seynabou Sakho have written a great piece explaining both why some firms choose not to formalize and what the benefits of formalization might be. You can read a short version here and a longer version here.

The authors find that Bolivian firms that are located close to a tax office are more likely to formalize. This finding is further evidence that initial registration costs and/or lack of information affect firms’ decisions to formalize.

The really important contribution of the authors, however, is their estimate of the effect of formalization on profits. They say:

The marginal firm who is only informal because of lack of information stands to almost double profits by registering. This estimate is robust to a number of controls for possible threats to our identification strategy, and suggests big gains to formalizing.

The authors go on to say:

Yet most informal firms are unlikely to want to become formal. Our results show big gains to firms whose lack of knowledge and travel costs prevent them from formalizing. The rest of the firms don’t stand to gain from formalizing.

In other words, there are some firms who would like to formalize, but they don’t do so either because the costs are high or because they lack the necessary information. Quite intuitively, these firms would see higher profits if they could formalize.

But some firms don’t formalize because they simply don’t want to. These firms are making the right decision—at least for their own well being—by staying informal. Their profits would not increase (and might even decrease) as a result of formalization.

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