to remain credit-constrained and/or to operate an archaic technology in the informal economy. Our model allows, in particular, to trace various categories of informal firms, with respect to their productivity potentials and the level of constraints they face, a useful characterization in tailoring policy actions to address informality and promote entrepreneurship. The model predicts that agglomeration has a non-monotonic effect on formalization of informal firms, and entrepreneurial profits increase with agglomeration effects.

This paper also contributes to the literature looking at policies designed to bring informal businesses and individuals within the reach of the tax system. Evidence is nuanced and the growth benefits of formalization are positive but heterogeneous across firm types. The smallest firms usually benefit the least while mid-sized firms typically benefit the most. Much economic informality seems to be explained as rational sorting of firms and workers based on inherent productivity characteristics and so formalization _per se_ may not address the fundamental determinants of productivity (Oviedo and others, 2009). In addition, corruption or poor public services may also reduce workers’ and firms’ willingness to formalize and pay taxes. A World Bank (2007) report shows a strong and significant relationship between informal behavior of the firm (measured as tax evasion), and the incidence of corruption (measured by extortion from public officials). Torgler and Schneider (2007) also look at how institutions affect individuals’ decisions to stay informal or to join the formal economy. In particular, they look at how tax morale—which is a measure of how justifiable people think it is to avoid paying taxes—is associated with informality. They found that this measure is highly correlated with institutional measures such as rule-of-law, and corruption. Their result highlights the role of individual’s trust in the ability of the public sector to serve the public interest when they decide to participate in the established social and economic system, versus instead deciding to stay informal. In a recent paper, Benhassine et al. (2018) used a randomized experiment in Benin, to document how formalization rates can be enhanced by policies that aimed at providing information, training, and support in opening a bank account to business. However, they found no significant gains in sales, profits, or welfare. The international evidence is cautionary against expecting a quick growth dividend from policies to encourage formalization. As rightly pointed out by Oviedo and others (2009), strengthening enforcement will work best when the appropriate incentives to formalize are created, so that informal agents have a viable transition path from informality to formality. Strengthening enforcement only may not be growth-enhancing. Policy packages can comprise a series of carrots and sticks that need to be adapted to the nature of informality in the country. In some countries, regulatory reform might be more relevant, while in others it could be regulation enforcement, administrative reform or tax reform. In this paper, we provide evidence of how investing in local infrastructure, increasing access to finance, 3