# **1. Introduction**

The majority of firms in most developing countries are informal. In Sri Lanka, for example, only one-fifth of firms operating without paid workers are registered with any government agency. Even among firms employing paid workers, the majority are unregistered with one or more pertinent agencies. Policymakers are concerned about high levels of informality for two reasons. First, informality is associated with lower tax collection, restricting the government’s ability to finance public services (Levy 2008). Second, the coexistence of formal and informal firms means that firms competing in the same industry face different marginal production costs (e.g., labor costs and taxes), leading to an inefficient allocation of resources in the economy (Hsieh and Klenow 2009; Levy 2008). How can informal firms be induced to formalize?

A firm’s decision to become formal depends on the costs and benefits of formality. There are two prevailing views of informality, dubbed by Perry et al. (2007) as _exclusion_ and _exit_ . The exclusion view focuses on the costs of registering. This view is most notably associated with the work of de Soto (1989), who argued that burdensome entry regulations prevent small firms from becoming formal. These firms suffer a loss in productivity as a result of remaining informal. The natural policy response is then to remove the burdensome regulations. Spurred in part by the World Bank/IFC _Doing Business_ project, governments around the world have in recent years streamlined the process of becoming formal. Indeed, since 2004, 75 percent of the countries included in the _Doing Business_ survey have adopted at least one reform making it easier to register a business (IFC, 2009).

But is streamlining the registration process sufficient to spur formality? The exit view focuses more attention on the balance between the costs and benefits of formality. The decision to become formal is comparable to any other investment decision taken by the firm. Each firm compares its perceived costs of being formal—including both initial registration and ongoing costs (e.g., tax payments)—with its perceived benefits of being formal (e.g., access to banks and courts and to government contracts). More able firm owners with larger efficient scales rationally become formal as they grow large enough to benefit from the formal institutions of civil society. Smaller, less productive, firms do not find formality desirable because they receive no benefit from access these formal institutions (Maloney, 2004).

We conduct a field experiment in Sri Lanka which reduces the information costs and increases the monetary benefits of formalizing in order to measure the latent demand for formalization, and the consequences that formalizing has on informal firms. We divided a sample of informal firms with 1 to 14 paid employees into four treatment groups and a control group. The first treatment group was given information about the costs and benefits of, and procedures for, registering their firm at the division level with the Divisional Secretariat (DS) – the relevant registration for tax purposes. Additionally, they were reimbursed for the (modest) direct cost of registration if they registered. The second, third, and fourth 2