Enterprise Surveys 92275 Enterprise Note Series Informality Does Firm-size Matter in the Informal Sector? 2014 Mohammad Amin and Xie Huang N ewly available data on informal firms in 11 African countries shows that informal firms while generally small can vary substantially in size. Using these data, this note explores the relevance of firm-size among informal firms. Data show that firm-size is important in the informal sector. For example, compared with the relatively small informal firms, large informal firms are less productive, have more educated owners, show a greater willingness to formalize or register and are more likely to use banks and microfinance institutions to finance their day-to-day operations. Hence, policies aimed at the informal Enterprise Note No. 28 sector could benefit from distinguishing between small and large informal firms. Introduction unregistered or the informal sector (see for example, La Porta and Shleifer 2008).It is well known that firms in the There is a large and growing body of work that highlights informal sector (henceforth, informal firms) are very small important differences between small and large firms, and often run by the owner himself/herself; they do not especially in the formal sector. Presence of sunk costs and engage in R&D, do not export and most of them have scale economies not just in the production process but also difficulty getting finance from banks and other organized in exploring and developing new markets and dealing with financial institutions. For example, for the 11 countries and the business climate and government officials could explain 1,349 informal firms in Africa that the present note focuses some of these observed differences. For example, studies on, about 30 percent of the firms have a single employee show that compared with small firms, large firms are more (including the owner/manager if he/she works at the firm), likely to engage in research and development and also spend 24 percent have 2 employees, 15 percent have 3 employees larger amounts on it (Cohen and Klepper 1996);however, and the remaining 30 percent have more than 3 employees. innovations per dollar spent on R&D are lower among the The mean number of employees at the firm equals 3.1 and relatively large firms (Acs and Audretsch 1991 and Plehn- the median value is 2 employees. Given the relatively small Dujowich 2006). Exporting activity is also concentrated size of the bulk of informal firms one wonders if firm-size has among large firms. According to the new Exporter any relevance at all for the informal sector. Dynamics Database (2012) compiled by the World Bank, a The issue of heterogeneity in the informal sector in World Bank Group few large companies dominate export markets in developing developing countries has been discussed in the literature (see and developed countries, with the top 1 percent often for example, Cunningham and Maloney 2001 and Mead accounting for more than half—and sometimes nearly 80 and Morrison 1996). However, the relationship between percent—of total exports. Another strand of the literature firm-size and diverse sets of issues such as firm productivity, finds that large firms enjoy better access to finance while growth, willingness to register, sources of finance, education the adverse effects of a poor financial system are magnified level of the owner(s), infrastructure availability, etc., has not on the smaller firms (see for example, Beck et al. 2005). been much discussed. Using data from Enterprise Surveys Other elements of the business climate like corruption, on informal firms in 11 countries (discussed below), Amin anticompetitive practices, etc., have been shown to hurt the (2013)looks at the issue of firm-size and its correlation smaller firms more than the larger firms although this body with a large number of firm-level variables. This note of work is still in a nascent stage. summarizes some of these results and also explores new However, in many developing countries, a substantial ones. Understanding the relevance of firm-size for informal proportion of output and employment originates in the firms is important not just for academic reasons but also checking our results, we found some differences in how from a policy perspective. For example, if we do find firm- various firm characteristics relate to employment versus size to be correlated with a firm’s desire to register, ease with sales. This note focuses on the employment measure for which a firm can access external sources of funds, etc., then two reasons. First, the employment measure is reported by policy measures can be appropriately targeted between small a larger number of the sampled firms than the sales measure and large informal firms. (91 vs. 82 percent, respectively). Second, given the small The data we use comes from a survey of informal firms number of workers employed by the firms, we suspect that in 11 countries in Africa conducted by the World Bank’s firms are less likely to make an error in recalling employment Enterprise Surveys between 2009 and 2011. The countries than in recalling sales figures. Nevertheless, extension of the include Angola; Botswana; Burkina Faso; Cameroon; results to the sales measure of firm-size would be a fruitful Cabo Verde; Congo, Democratic Republic; Côte d’Ivoire; area for future research. Madagascar; Mali; Mauritius and Rwanda. The number The results discussed below are obtained using appropriate of firms surveyed range between 99 (Botswana) and 240 regression analysis. Unless stated otherwise, all the results (Rwanda) and total 1,487 across all 11 countries. The discussed below are statistically significant at the 10 percent surveys cover only the unregistered (i.e. informal) firms level or less and they are robust to country and sector (firm and are restricted to 1 or 2 main cities in each country. manufactures the product or not) fixed effects. We note that Due to lack of adequate information on the universe of our results hold in the full sample and not necessarily in any informal firms (sampling frame), the surveys do not claim given individual country. We do check that a single outlier to be representative of the informal economies either at country is not driving the results. The results are as follows. the country or the city level. Hence, the results presented below should be treated with due caution as pertaining to Smaller firms have higher labor productivity the surveyed firms rather than the larger informal economy. We define firm-efficiency or labor productivity as the (log The measure of firm-size we use is the log of number of of) sales in a regular month over the last year divided by the employees working at the firm during a regular month in total number of employees working at the firm in a regular the last year prior to the date of the survey (Employment). In month over the last year. Ceteris paribus, one would expect the full sample, the mean value of Employment equals 0.856 labor productivity to decrease with firm-size since larger (or 3.1 employees without logs) and the standard deviation firms have resources or other inputs spread out more thinly equals 0.717 (2.9 without logs). That is, the coefficient of across workers. Of course, this tendency for diminishing variation (standard deviation as a percentage of mean value) returns to labor could be countered if more workers imply of Employment variable equals 83.8 percent. Individually more of other complementary inputs. across countries, the coefficient of variation ranges between The results indeed show a sharp decline in labor productivity a low of 43.8 percent in Angola and a high of 108 percent as the number of workers at the firm increases (figure 2).1 in Mauritius. In other words, there is substantial variation in For example, the median level of labor productivity equals firm-size to warrant an analysis (figure 1). USD 152 (per month) among firms with 2 or less employees Information is also available in the survey on the monthly (below median employment). The corresponding figure for sales of the firm over the last year. As expected, sales and firms with more than 2 employees is much lower at USD employment figures show a high positive correlation 131. Note that the latter is about 86 percent of the former. (correlation coefficient of 0.38) and this is statistically To be more conservative, we take firm-level factors such as significant at less than the 1 percent level. However, cross- female ownership, whether firms manufacture products, Figure 1 Size distribution of the firms in the sample 35 30.3 30 24.3 Frequency (%) 25 20 15.3 15 11.0 10 7.1 5 3.9 2.3 1.9 1.2 0.9 0.2 0.1 0.1 0.5 0.4 0.2 0.1 0.1 0.2 0.1 0.1 0 -1.2 -0.2 0.3 0.7 1.1 1.3 1.5 1.7 1.9 2.0 2.3 2.4 2.5 2.6 2.8 3.0 3.1 3.2 3.3 3.4 3.8 Standardized values of (log of) number of employees in a regular month ■ Frequency (% of sample) Source: Enterprise Surveys. 2 Figure 2 Labor productivity decreases Figure 3 Larger firms have more with firm-size educated owners 6 1.4 Sales per worker in a regular month 4 1.19 1.16 1.2 Number of employees in a regular month (logs) 0.95 (logs, residuals) 1.0 0.91 2 0.8 0.73 0 0.6 0.4 -2 0.2 0.0 No Primary Secondary Vocational University -4 education education education training degree -2 -1 0 1 2 Highest education level of the owner Number of workers in a regular month (logs, residuals) coef = .44330617, (robust) se = .09156872, t= -4.84 Source: Enterprise Surveys. Source: Enterprise Surveys. Note: The figure is a partial scatter plot obtained after controlling for country fixed effects, age of the firm (logs), and separate dummy variables indicating if the firm has a female owner, firm uses machinery, firm uses electricity and if the firm manufactures the product itself. The Large firms show a greater willingness or negative relationship shown is significant at less than the 1 percent level preference to register than small firms with Huber-White robust standard errors clustered on the country. One observation is dropped in the figure above (outlier) although this does It is commonly believed that registration—the move from not change any of the results in the figure or in the text above. informal to formal sector—is beneficial to the economy in etc., into consideration and still find a negative relationship terms of tax revenues, better compliance with laws, etc. between labor productivity and employment. This finding There are some benefits to the firm too, such as better indicates that expanding employment in the informal access to finance, greater protection provided by the the sector may require provision of complementary (to labor) law, etc., but these do come with the attended cost of taxes resources so that labor productivity and therefore income and compliance with the laws. Hence, the question arises level of the informal workers does not decrease too much as whether informal firms are willing to register or not. In one the sector expands. of the survey questions, firms were asked if they would like to be registered. Nearly 59 percent of the firms answered in Large firms have more educated owners the affirmative. A greater proportion of small firms than than small firms large firms in Angola and Burkina Faso showed willingness to be registered; however, in the full sample, the desire to The importance of education can hardly be exaggerated. register was much more common among large firms than For one, education implies greater and better quality of small firms. According to the most conservative estimate human capital and therefore greater ability to benefit from based on controlling for some important firm characteristics, existing opportunities. Focusing on the education level of the a unit increase in the number of employees (without logs) largest owner (henceforth owner) of the firm, only 9 percent is associated with an increase of 9 percentage points in the of the firm owners in our sample have no education at all. likelihood of a firm wanting to be registered (against the The overwhelming majority have some education including mean level of 59 percent). Figure 4 illustrates the point. primary education (32 percent), secondary education (35 The survey also asked firms if registering would benefit percent), vocational training (14 percent) and university them through better access to finance, better access to degree (11 percent). In our sample, education level of firm raw materials, infrastructure and government services and owners is higher among the relatively larger firms (figure through less bribes to pay. We find no evidence that the 3). However, this positive correlation between the level of likelihood of a firm reporting any of these benefits differs education of the owner and firm-size is primarily due to significantly by firm-size. Similarly, a firm’s perception of the differences in firm-size between owners with secondary, maximum and minimum time it takes to register a business primary or no education vs. the rest of the owners who have is roughly same for firms of different sizes. vocational training or university degree. A unit increase in the number of employees at the firm is associated with an Large firms are more likely to use banks and increase of 12.2 percentage points in the likelihood of the microfinance institutions than small firms in firm having an owner with vocational training or university order to finance their day-to-day operations degree rather than having just primary, secondary or no education at all. Focusing on financing of day-to-day operations of the 3 Figure 4 Large firms are more likely to express the desire to register than the small firms 120 100 Percentage of firms expressing 100 87 85 desire to register 80 69 74 65 66 68 63 61 55 57 60 54 49 44 46 40 32 19 20 0 Angola Burkino Cabo All countries DRC Cameroon Mali Rwanda Botswana Faso Verde (average) ■ Small firms ■ Large firms Source: Enterprise Surveys. Note: Small firms are those firms that have less than 3 employees in a regular month and the rest are large firms. DRC in the figure is Congo, Democratic Republic. firm, it is well known that informal firms rely heavily on Summarizing, using newly available data on informal their own funds. This is supported by our sample as well firms in 11 African countries, this note explores whether with 91 percent of the firms reporting use of own funds firm-size matters within the informal sector. Is there a to finance their day-to-day operations. Nevertheless, use of meaningful distinction between large and small informal other sources of finance is not entirely absent—21 percent firms and if so, in what ways? Results discussed show that of firms report using credit or advances from suppliers and compared with small firms, large firms are less productive, customers, 22 percent borrowed money from friends and more willing to register, have more educated owners and relatives, 7 percent used moneylenders, 4 percent used banks are more likely to make use of banks and microfinance and 5 percent used microfinance institutions. Somewhat institutions for obtaining finance. These results are a starting surprisingly, we find no significant differences between point and we hope that they will encourage more research small and large firms in the proportion of firms using own on the relevance of firm-size for the informal sector. funds (figure 5). Similarly, firm-size is uncorrelated with the likelihood of a firm using other sources of finance—except for banks and microfinance institutions. Large firms show a higher probability of obtaining financing from banks and microfinance institutions—considered separately or jointly—than the small firms. Figure 5 Large and small firms are equally likely to use their own funds to finance day-to-day operations 120 % of firms that use own funds to 100 100 finance day-to-day operations 95 98 99 98 94 100 92 92 91 91 91 90 90 90 89 87 89 82 83 83 83 84 78 80 60 40 20 0 Mauritius Cabo Madagascar Mali DRC All countries Botswana Rwanda Côte Angola Burkino Cameroon Verde (average) d’Ivoire Faso ■ Less than three employees in a regular month ■ Three or more employees in a regular month Source: Enterprise Surveys. Note: Small firms are those firms that have less than 3 employees in a regular month and the rest are large firms. DRC in the figure is Congo, Democratic Republic. 4 Notes References The negative relationship here is statistically weak and insignificant at 1.  Acs, Z. J., and D. B. Audretsch. 1991. “Innovation and Technological the 10 percent level without any other controls but becomes large and Change: An Overview,” In Acs, Z. J., and D.B. Audretsch (edited), significant (at the 1 percent level) once we control for country fixed Innovation and Technological Change: An International Comparison, effects. That is, the relationship is weak across countries but strong NY: Harvester Wheatsheaf. within countries.  Amin, Mohammad. 2013. “Relevance of Firm-size for the Informal Sector,” Mimeograph. Available at: http://works.bepress.com/ mohammad_amin/49/ Beck, T., A. Demirguc-Kunt and V. Makimovic. 2005. “Financial and Legal Constraints to Growth: Does Firm Size Matter?” Journal of Finance 60 (1): 137-77. Cohen, W. M., and S. Klepper. 1996. “A Reprise of Size and R&D,” Economic Journal 106 (437): 925–951. Cunningham, W. V., and W. F. Maloney. 2001. “Heterogeneity among Mexico’s Micro-Enterprises: An Application of Factor and Cluster Analysis,” Economic Development and Cultural Change 50 (1): 131-156. La Porta, Rafael, and Andrei Shleifer. 2008. “The Unofficial Economy and Economic Development,” NBER Working Paper 14520, NBER, Cambridge, USA. Mead, D. C., and C. Morrisson. 1996. “The Informal Sector Elephant,” World Development 24 (10): 1611–1619. Plehn-Dujowich, J. M. 2006. “Innovation, Firm Size, and Adverse Selection,” Unpublished Working Paper. The Enterprise Note Series presents short research reports to encourage the exchange of ideas on business environment issues. The notes present evidence on the relationship between government policies and the ability of businesses to create wealth. The notes carry the names of the authors and should be cited accordingly. The findings, interpretations, and conclusions expressed in this note are entirely those of the authors. They do not necessarily represent the views of the International Bank for Reconstruction and Development/World Bank and its affiliated organizations, or those of the Executive Directors of the World Bank or the governments they represent. 5