Formal Sector Incentives and Informality

Ama Baafra Abeberese and Ritam Chaurey


Informal firms account for over half of output and employment in developing countries. To analyze the barriers to formalization, most of the literature has focused on entry costs in the form of registration fees, rather than on the ongoing costs and benefits of being a formal firm. This paper is the first to study the effect of a simultaneous change in ongoing formal sector costs and benefits on formalization. We analyze an Indian scheme that provided tax exemptions and capital subsidies to formal firms, thereby increasing the benefits and reducing the costs of formal firms. Using a complete enumeration of firms and a difference-in-differences approach, we find that the scheme led to an increase in the registration of existing informal firms, in particular, male-owned firms, urban firms and firms with access to external financing. We find some evidence that the increase in registration was primarily driven by the tax exemption rather than the capital subsidy.

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