# **1. Introduction**

There a large number of studies on the relationship between informality and firm productivity and, for the most part, the literature finds a negative relationship between the two. For example, Perry et al (2007), using data from the World Bank’s Enterprise Survey Database, find a negative correlation between output per worker and various indicators of formality in Argentina, Bolivia, Mexico, Panama, and Peru. Although their analysis controls for a series of firm and location characteristics, it does not take into account the potential endogeneity of a firm’s formal or informal status. In fact, in a study specific to Peru—a country for which Perry et al (2007) find the largest gap in productivity between formal and informal firms—World Bank (2008) finds no statistically significant effect of formality on firm profitability once selection controls are added to the equation. On the other hand, country-specific studies in Bolivia (McKenzie and Sakho, 2010; World Bank, 2009) and Mexico (Fajnzylber et al, 2009) do find a negative relationship between informality and firm profitability even after controlling for the potential endogeneity bias. World Bank (2010) reports similar findings for the relationship between informality and firm productivity in Turkey and Fajnzylber et al (2006) identify a negative impact of informality on firm revenues in Brazil.

This paper estimates a relationship between informality and firm profitability using a new survey of more than 1,200 small urban manufacturing and service firms conducted in Ecuador in May-June 2011. The richness of the survey allows for a variety of controls for firm, owner, and geographic characteristics, as well as for identifying determinants of informality which attempt to address the endogeneity problem. The paper finds that informality has a significant negative impact on profitability and productivity for otherwise comparable firms, and this finding is robust to different measures of informality and profitability. The paper also provides some evidence on the determinants of this relationship, such as the ability to avoid fines, issue receipts, and obtain improved access to credit for more formal firms.

The remainder of the paper is structured as follows: Section 2 presents a profile of the surveyed firms, focusing on those characteristics which are particularly relevant to the paper’s analysis; Section 3 develops a simple model of profitability and formality and discusses estimation issues; Section 4 presents the estimation results; Section 5 discusses the channels through which formality affects profitability; and Section 6 offers some concluding remarks.

# **2. What are the main characteristics of surveyed firms and their owners?**

## **2.1 Data**

The data used in this paper come from a new survey of firms with 1-50 employees designed specifically for this study. The survey, the Ecuador Micro-Enterprise Survey (EMES), focused on the eight most important sectors of urban economic activity: textiles, apparel, shoes, and leather manufacturing; other manufacturing; grocery retailing; street food vendors; hotels and restaurants; ground transport; auto repair; and construction. The survey respondents were the "individual ultimately responsible for the operations of the company or business" and the participating firms were chosen through random geographic sampling by census tract in Quito, Guayaquil, Machala, and Tulcán.<sup>1</sup> Firm size was defined

> 1 The universe of firms that the EMES survey represents—namely, firms with 50 employees or less operating in manufacturing and service sectors in Quito, Guayaquil, Machala, and Tulcán—represent 28 percent of the total number of economic establishments in Ecuador according to the Economic Census (INEC, 2010).

2