# **4. Does formality matter for profitability?**

The set of independent variables in equation (3.1)—gender, age, education, entrepreneurial ability, and family business history of the owner, hours worked in the business, membership in a guild, ownership of the place of business, density of firms in the parish, average distance of firms in the parish from the municipal office and the nearest tax office, the incidence of inspections in the parish, and size, sector, and city dummies—explain more than 41 percent of the variation in the log of monthly profits (column 1 of Table 1). The coefficient estimates on most variables are as expected: firms earn higher profits when the owner spends more time working in the firm, when the owner is more educated and more entrepreneurial, when the owner takes advantage of networking and other opportunities offered by guild membership, and when firms own their place of business rather than renting it. Neither owner age nor gender significantly affects firm profits; this is explained by the fact that they do not offer additional explanatory power in the presence of controls for sector of activity and owner’s education.<sup>12</sup> Larger firms earn greater profits even when controlling for other determinants of profitability; moreover, profits are highest in restaurants and hotels and lowest for street food vendors. Among locations, Quito turns out to be the most profitable city.

The addition of four variables which reflect the regulatory requirements of operating formally—having a RUC, issuing and requesting receipts, affiliating employees with IESS, and having a municipal license— to the estimated equation increases the predictive power of the model by more than two percentage points (column 2 of Table 1). Firms with a RUC earn 21.5 percent higher monthly profits than unregistered firms, while a 1 percent increase in the share of workers with social security affiliation is associated with 0.4 percent higher profits. Neither having a municipal license nor using receipts has a significant impact on profits, although coefficient estimates are positive in both instances. In the case of receipts, this result is explained by inter-dependency between having a RUC and issuing receipts: a firm must have a tax identification number before it is able to give receipts. In fact, if the RUC variable is removed from the estimation equation, the receipts variable becomes statistically significant with a semi-elasticity of 13.7 percent. Broadening the definition of formality to seven aspects previously discussed does not qualitatively change any of the results; in addition, we find that issuing written contracts to employees and inclusion in the commercial registry have a further significant impact on profits with an elasticity of 0.5 and a semi-elasticity of 0.3, respectively (column 3 of Table 1).

Columns 4 and 5 of Table 1 aggregate the narrow and wide definitions of formality, respectively, into a single variable _Fi_ by extracting the first principal factor of the combination of these variables.<sup>13</sup> The results show that higher values of the formality index are positively and highly significantly associated with increased profitability.<sup>14</sup> The estimated magnitude of the φ coefficient suggests than a one standard deviation increase in the value of the formality index raises enterprise profits by 22-36 percent, depending on whether the narrow or the wide definition of formality is used.<sup>15</sup> The positive relationship between formality and profitability remains robust to our attempts to control for endogeneity by using instrumental variables. Columns 6-9 of Table 1 show the results of estimating

> 12 The signs on the gender and age coefficients and their lack of statistical significance are similar to results obtained from similar studies in Bolivia (McKenzie and Sakho, 2010) and Peru (World Bank, 2008).

> 13 This amounts to estimating equation (3) by OLS, without explicitly addressing the identification issue.

> 14 The results in this paragraph are robust to using the alternative, equal-weighted index of formality.

> 15 The (principal factor) formality index is distributed with a zero mean and a standard deviation of 0.84-0.86 (for the narrow and wide definitions, respectively).

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